Monetary Policy

Dear client,  In addition to this abridged Strategy Report, we are sending a report written by Arthur Budaghyan, Chief Strategist of BCA’s Emerging Market Investment service. Arthur shares his thoughts on the future of Chinese TMT stocks, a subject we trust you will find insightful and beneficial. Jing Sima China Strategist Highlights Wealth and income inequality may be the most important contributors to rising populism in the past three decades. China has its share of increasing populism; reducing income inequality and improving social welfare are core principles of President Xi’s reform agenda. July’s economic data continues to indicate a softening in China’s economy. However, the magnitude of the slowdown is within policymakers’ pain threshold while the economy remains supported by strong external demand. For now, stay underweight in Chinese stocks within a global equity portfolio.  Policy stance has yet to turn reflationary. Feature Populism Takes Root BCA's China Investment Strategy has argued that China is accelerating the pace of its structural reforms; addressing income inequality is at the core of the current administration’s reform agenda. Wealth and income inequality may be the most important structural cause of rising global populism and political polarization (Chart 1). The severity of income inequality in China is illustrated in Chart 2. It is noteworthy that China, whose political and economic ideology is based on creating a classless society, has found itself not far behind the US in terms of a widening wealth and income gap. Chart 1Populism Has Been On The Rise Globally For The Past 30 Years Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China Chart 2The Great Gatsby Curve Paints A Not-So-Great Equality Picture Of China Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China The relationship between inequality and intergenerational income mobility is captured in the "Great Gatsby Curve" – a concept based on a research paper by economist Miles Corak and later introduced by Alan Krueger, the late professor and Chairman of the Council Economic Advisers, during his speech at the Center for American Progress in 2012.1 The US has experienced a sharp rise in wealth and income inequality since the 1980s. On the eve of the Global Financial Crisis, income inequality in the US was as sharp as it had been since the time of "The Great Gatsby” novel set in the 1920s. After three decades of rapid industrialization and economic expansion, China also faces the challenge of escalating income inequality and discontent among middle-class households. Populism, defined as political stances that emphasize the idea of "the people", often benefits middle-class households, but not big business or corporate earnings (“the elite”). An increase in populist governments is usually positively correlated with rising number of antitrust investigations, since populist leaders tend to pander to popular outcries against big corporations by limiting or breaking up the corporations. In the US, the rise of Reaganism/neoliberalism in the 1980s led to a big drop in antitrust cases – a trend that was sustained for nearly three decades as the free-market Washington Consensus pushed against antitrust and other populist stances (Chart 3). However, the tide turned in 2016 when the US elected a populist president for first time, and antitrust threats started reemerging (Chart 4). Chart 3Antitrust Reinforcement In The US Has Been On A Secular Decline In The Past Two Decades… Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China Chart 4...But Antitrust Noise Is Getting Louder In The US (And Lately In China) ...But Antitrust Noise Is Getting Louder In The US (And Lately In China) ...But Antitrust Noise Is Getting Louder In The US (And Lately In China) Both China and the US have transitioned towards larger government involvement in the economy.  More restrictions on private enterprise and a greater redistribution of wealth will be forthcoming. In the US, there has been a shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 5). In China, the “dual circulation” economic goal set by the 14th Five Year Plan, coupled with an economic divorce between the Middle Kingdom and the US, requires that China expands its domestic market. However, that expansion is constrained by its relatively low labor share (Chart 6). The external and internal challenges are fertile ground for rising and sustaining populism. Thus, reforms that promote the bargaining power of workers at the expense of corporate earnings will likely become a secular trend in China. Chart 5Labor Makes A Comeback Versus Capital In The US... Labor Makes A Comeback Versus Capital In The US... Labor Makes A Comeback Versus Capital In The US... Chart 6...And In China Too ...And In China Too ...And In China Too Checking In On The Data China’s economic data continues to soften as evidenced by a slew of new numbers published last weekend. On the growth front, the contraction in the volume of imports in the past two months reflects the sagging domestic economy, despite elevated commodity prices supporting the value of total imports (Chart 7). Global demand for Chinese goods, on the other hand, remains strong compared with the historical norm, and continues to offset weaknesses in China’s old economy sectors. Meanwhile, Chinese producers face persistent inflationary pressures stemming from elevated global commodity prices and a broken price transmission to pass on inflation to domestic consumers (Chart 8). Instead of stimulating demand in the near term, Chinese policymakers will likely address supply-side issues by releasing strategic reserves and curbing raw material exports, and relaxing domestic production restrictions. Chart 7Strong External Demand Continues To Offset Domestic Economic Weaknesses Strong External Demand Continues To Offset Domestic Economic Weaknesses Strong External Demand Continues To Offset Domestic Economic Weaknesses Chart 8Inflationary Pressures On Producers Remains Elevated Inflationary Pressures On Producers Remains Elevated Inflationary Pressures On Producers Remains Elevated We expect that Beijing will need greater economic pain before it decides to stimulate the economy more substantially. Monetary conditions have eased since earlier this year on the back of rising inflation, falling real interest rates and recently a breather in the RMB’s ascent (Chart 9). Nonetheless, as we noted in a previous report, a decisive rebound in the rate of credit expansion requires clear easing signals from China’s top leadership for local governments and corporates to ramp up leverage again. The July Politburo meeting pledged more fiscal support for the economy this year. Meanwhile, policymakers have intensified their tough regulatory stances on private-sector businesses and oversight on the public-sector’s balance sheet. Hence, the current policy backdrop does not suggest any imminent or meaningful reflationary measures. Chart 9A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing Chart 10War Against Delta-Variant Remains A Risk War Against Delta-Variant Remains A Risk War Against Delta-Variant Remains A Risk The COVID-19 Delta-variant remains the biggest risk to our view. The mutated virus has spread to 14 provinces in China and triggered the strictest pandemic-control measures since Q1 last year. The drag on the service sector’s activities and employment will be substantial if measures are maintained for more than a month (Chart 10). In this case, the leadership may need to step in with policy supports to stabilize the economy and sentiment. For now, the pullback of stimulus and ongoing regulatory tightening since Q4 last year continue to dominate China’s financial assets. Thus, investors should maintain an underweight allocation to Chinese equities within a global equity portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Krueger, Alan (12 January 2012). "The Rise and Consequences of Inequality in the United States" (PDF).  Market/Sector Recommendations Cyclical Investment Stance

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? China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 2Reconciliation Bill Also Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 3Biden Cannot Spare A Single Vote In Senate China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 … China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden 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 Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia'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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China'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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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? German Election Polls Point To Gridlock? German 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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 Geopolitical Tailwinds To European Equities Geopolitical 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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 13Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Japan 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 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 Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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 Hypo-Globalization Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Trade 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? Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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 Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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) Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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... Beijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware China Tech: Buyer Beware China 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 China's Pain Threshold = Property Sector China'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 Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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 Fertility Fell In Japan Despite Falling Prices Fertility 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 China Will Ease Policy... Or India Will Break Out China 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 Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Chart 13India Likely To Expand Fiscal Spending Soon Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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 Emerging Markets: Not Out Of The Woods Yet Emerging 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. Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) 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 China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The dollar smile theory was valid around the COVID-19 crisis but does not stand the test of time. A more useful framework for determining the long-term trend in the dollar is observing global business cycle dynamics. The 2000s experience could provide a useful roadmap for the dollar this coming decade. We remain dollar bears over a 9-to-12-month horizon, although the dollar could stage a short-lived rally in the interim. Feature The “dollar smile” theory1 is the premise that the dollar tends to rise when the US economy is either too strong or too weak. Only in the precise environment, when the US economy is neither too hot nor too cold would you experience a dollar decline (Chart I-1). Chart I-1The Dollar Smile Theory The Dollar Smile Theory The Dollar Smile Theory This theory particularly resonates with traders and financial speculators as each handle of the smile can be explained by economic theory. For example, when the US economy is running hot, this usually prompts the Federal Reserve to hike interest rates. This supports the dollar. When the US economy is entering a recession, this is generally accompanied by a flight to safety. Inflows into safe-haven US bonds and defensive sectors of the stock market would also tend to boost the dollar. The fact that the dollar can rise in these polarizing set of circumstances makes a long dollar view particularly attractive as the default position. The key questions therefore for investors are: First, how does this theory hold up in terms of evidence? and, second, how should FX portfolios be positioned in the current environment? The Evidence During the height of the COVID-19 crisis, the smile theory certainly proved correct. Chart I-2 shows that the DXY index tended to rise approximately 58% of the time when the S&P 500 was either up by 2% or down by 2%. However, when the sample size is broadened, even to a few years, the theory falls apart. From 2010-2020, the DXY index rose only 37% of the time when the S&P 500 was up 2%, while it rose almost 50% of the time when the S&P 500 was down 2% (Chart I-3). Meanwhile, this sample size is particularly biased since during that period, the dollar was in a bull market, and the US economy was quite strong. Chart I-2The Dollar Smile Around The 2020 Pandemic The Dollar Smile Theory The Dollar Smile Theory Chart I-3The Dollar Smile Around Full Business Cycles The Dollar Smile Theory The Dollar Smile Theory Chart I-4US Industrial Production And The Dollar: No Correlation The Dollar Smile Theory The Dollar Smile Theory In economic terms, we get a similar picture. The relationship between US industrial production and the greenback is weak at best, with little evidence of a smile (Chart I-4). For example, there was no discernable trend in the dollar when US industrial production was between 0-5%, or even 5-10%. Admittedly, the dollar does rise when US manufacturing is in recession. A More Useful Framework Chart I-5US Relative Growth And The Dollar: Linear Correlation The Dollar Smile Theory The Dollar Smile Theory While the dollar is a complex variable, explaining its longer-term trend boils down to two simple rules of thumb: Is the global economy recovering or contracting? And if so, is the US leading or lagging this recovery? Chart I-5 shows that the dollar tends to rise when US economic activity is picking up relative to the world, but tends to fall otherwise, albeit with a few outliers. Meanwhile, one of the reasons the US dollar has done well during recessions is that the US economy generally has had more shallow recessions than other advanced economies in recent years. Through this lens, the US performs comparatively better during global downturns (Chart I-6). Going forward, the IMF predicts that non-US growth should fare better than growth in the US over the next few years. We side with the IMF: The global economic recovery will remain intact and will rotate from the US to other economies. Chart I-6US Growth Usually Outperforms During Recessions The Dollar Smile Theory The Dollar Smile Theory Chart I-7Spectacular Recovery In Vaccinations Outside The US Spectacular Recovery In Vaccinations Outside The US Spectacular Recovery In Vaccinations Outside The US The primary rationale is that most G10 countries lagged the US in their vaccination campaigns in 2020 and earlier this year. That is starting to change now, as vaccinations in the rest of the G10 are ramping up (Chart I-7). Meanwhile, vaccinations are proving effective against death and hospitalizations for the Delta variant of the COVID-19 virus. A turnaround in the vaccination campaign would not only boost public opinion about the COVID-19 response but would also be a welcome fillip to much subdued consumer and business sentiment outside the US. Taking a step back, there is a strong case to be made that cyclically, both eurozone and Japanese growth could surprise to the upside due to pent-up demand. For the eurozone, the debt crisis from 2010-2012 was a severe blow to the recovery. In Japan, rolling crises from the Fukushima disaster in 2011 to the consumption tax hikes both in 2014 and 2019 were growth handicaps. Chinese monetary tightening in 2015 caused a sharp manufacturing recession that was a severe blow to non-US economies, including Japan and the eurozone. This time around, coordinated monetary and fiscal stimulus could allow for a few years of a genuine growth recovery. In a nutshell, the dollar smile that occurred around the pandemic last year was due to the uncertainty about the future path of growth, while the US was leading the world in both monetary and fiscal stimulus. The US also led in the vaccination campaign. As other economies adopt this template, the smile should fade, as has empirically been the case over time. Echoes From The 2000s The 2000s experience could provide a useful roadmap for the dollar in this coming decade (Chart I-8). US growth was underperforming the rest of the world during that time. The primary driver was a commodity boom driven by massive infrastructure spending in China. This time around, a concerted push towards green energy will sustain bull markets in metals such as copper, nickel, cobalt, aluminum, and silver, benefiting the economies of producer countries (Chart I-9). Leaders in building renewable energy infrastructure, such as Europe, could also see a boom as demand for their goods and services rise. Chart I-8A Roadmap For The Dollar In The Next Decade A Roadmap For The Dollar In The Next Decade A Roadmap For The Dollar In The Next Decade Chart I-9At The Cusp Of A New Commodity Super Cycle? At The Cusp Of A New Commodity Super Cycle? At The Cusp Of A New Commodity Super Cycle? The aftermath of the tech bubble bust created extremely easy policy settings for the US. The Federal Reserve cut interest rates to a low of 1% in 2003. Meanwhile, fiscal policy was much more accommodative than what was needed to close the output gap. The combination led to a massive expansion in the US twin deficits, a similar situation to today (Chart I-10). Chart I-10A 2000s Roadmap A 2000s Roadmap A 2000s Roadmap Chart I-11Real Yields: Now Versus Then Real Yields: Now Versus Then Real Yields: Now Versus Then Excess demand in the US started to create inflationary pressures, with headline inflation consistently between 2-4% from 2000-2008. Real rates in the US cratered, which hurt the dollar. This time around, inflation is rising fastest in the US (even if it is transitory). Meanwhile, The Fed is the only central bank that has an asymmetric inflation target. Other central banks (such as the Reserve Bank of New Zealand, the Bank of Canada or Norges Bank) have stated they will normalize policy, even though they also view their inflation as transitory. So real rates are and will be rising faster outside the US (Chart I-11). In short, most of the conditions that have usually characterized a dollar bear market for a decade or so are in place today. The Federal Reserve is committed to staying easy, US real rates are depressed, and growth should be stronger outside the US compared to within it, a similar template to what we saw in the 2000s. From A Dollar Shortage To An Avalanche The dollar smile theory works particularly well when there is a shortage of dollars, like in 2020. The lack of dollar liquidity was a tailwind behind the dollar bull market during the last decade. Today, the Fed’s balance sheet is still expanding, and the massive liquidity injection from quantitative easing has tremendously improved the global supply of dollars. One measure of global dollar liquidity is the sum of the Federal Reserve’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has exacerbated a blow-up somewhere, typically among other countries running twin deficits (Chart I-12). For example, since the global financial crisis, a deceleration in this measure coincided with the European debt crisis, the China slowdown, and more recently, the COVID-19 crisis, with steep depreciation in many procyclical currencies and a vicious rally in the dollar. Chart I-12An Explosion In The US Monetary Base An Explosion In The US Monetary Base An Explosion In The US Monetary Base Fast forward to today and it is difficult to imagine such a scenario playing out over the next 9-12 months. The Fed has swap lines with many foreign developed and emerging market central banks that can draw on dollar liquidity until the end of this year. These lines are likely to be extended if the economic environment deteriorates before year-end. Meanwhile, the lack of uptake from these lines suggests foreign central banks are flush with dollars (Chart I-13). The Federal Reserve’s custody holdings also argue that there is little shortage of dollars internationally, compared to 2008 or 2020 (Chart I-14). With the US current account deficit widening, outflows of US dollars will continue to keep global dollar liquidity flush. Chart I-13Swap Lines Are Not Being Tapped Swap Lines Are Not Being Tapped Swap Lines Are Not Being Tapped Chart I-14Custody Holdings Are Picking Up Custody Holdings Are Picking Up Custody Holdings Are Picking Up Cross-currency basis swaps are well contained, suggesting no US dollar funding pressures abroad. Chart I-15Rising Non-USD Debt Rising Non-USD Debt Rising Non-USD Debt It is important to note that euro- and yen-denominated debt are also expanding (Chart I-15). These are smaller in outstanding amounts than US-denominated debt but reflect the gradual shift in the allocation of currencies away from dollars. In a nutshell, the system is awash with both dollars and other international reserve currencies, limiting the negative feedback loop that dollar shortages have usually triggered. Concluding Thoughts We made the case last week that the dollar is experiencing a countertrend bounce, likely to continue over the next month or so. Beyond that, however, the dollar should depreciate towards the end of the year into next year. Meanwhile, our analysis suggests the dollar smile theory works best near recessions when the US economy is likely to outperform and the safe-haven status of US Treasuries is likely to buffet the greenback. Outside of these periods which represent only 5% of the last four decades, the dollar smile theory falls apart.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2   There were a few strong data releases out of the US: Inflation continues to inflect higher in the US. Headline CPI came out at 5.4% versus expectations of 4.9% in June. Core came in at 4.5% versus expectations of 4.0%. The PPI report was equally robust, with core prices rising well above expectations to the tune of 5.6%. The NFIB small business optimism survey jumped from 99.6 to 102.5. Empire manufacturing data for July was 43 versus 17.4 the prior month. The US dollar DXY index is up 0.4% this week. The big data release was the increase in US inflation but relative calm in bond markets seems to cement the view that financial participants consider it transitory. There is still scope for the US dollar to work off oversold conditions, but our bias is that it will be lower in the next 9-12 months.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2   There was scant data out of the eurozone this week: The Bloomberg GDP survey showed that both Q2 and Q3 GDP growth were revised higher. 2022 growth was also revised higher from 4.2% to 4.3%. In the same survey, there was no change expected in policy rates in the foreseeable future. CPI across eurozone countries was in line with expectations: 2.5% in Spain, 2.1% in Germany and 1.9% in France for the month of June. Over the weekend, in a Bloomberg interview, Christine Lagarde told us to expect a significant update to the eurozone’s monetary policy and forward guidance in the July 22 meeting. Our bias is that given the new symmetric inflation target, PEPP will be rolled over into a new program, revised asset purchases will be announced to accommodate for climate change, and possibly more forward guidance that gives us a window into when the ECB will exit negative rates. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2   There was some positive news out of Japan this week: Core machine orders rose 12.2% year on year in May, versus an expectation of a 6.3% increase. PPI came in at 5% year on year in June, in line with expectations. Machine tool orders rose 97% year on year in June. Importantly, domestic orders grew faster. The yen was down 0.14% against the dollar this week, after a stellar performance last week. The yen continues to sit in a sweet spot among G10 currencies. Falling nominal yields elsewhere are increasing the appeal of yen cash in real terms. Meanwhile, there is the upshot of cyclical improvement in Japan, which will benefit inflows into yen assets.   Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2   There was significant data out of the UK this week: The 3-month-on-3-month GDP release for May came in at 3.6%, below expectations. Industrial production growth for May was 20.6% year on year, below the 27.5% increase in April. The trade deficit improved from GBP 11bn to GBP 8.5bn. CPI was above target in June, with core at 2.3% and the RPI at 3.9%. The house price index rose 10% year on year in May. Employment increased 25K in May, which disappointed expectations of a 91K increase. The pound rose 0.5% against the US dollar this week. The market reacted positively to the upside surprise in inflation, suggesting the BoE might normalize policy sooner than expected.   Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2   There were a few important data releases out of Australia this week: NAB business conditions deteriorated. The conditions component fell from 37 to 24 in June, while the confidence component fell from 20 to 11. Westpac consumer confidence rose slightly to 108.8 from 107.2 in July. The employment report was better than expected. There were 29.1K jobs added in June, pushing the unemployment rate down to 4.9%. The mix was also great with 51.6K full-time jobs added versus a loss of 22.5K part-time jobs. The AUD was up 0.13% this week against the USD. Melbourne has joined Sydney in the lockdown, and so there is room for economic data to keep disappointing over the next few weeks. In hindsight, the RBA’s decisively dovish bias relative to other central banks seemed to be the appropriate strategy. In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2   The was scant data out of New Zealand this week: REINZ house prices rose 6.2% year on year in June. Net migration for May was 1182 versus 1087 the prior month. The NZD was up 60bps versus the US dollar this week. While the RBNZ kept interest rates at 0.25%, it signaled QE will end on July 23, a full year ahead of schedule. Markets are now priced for a rate hike as early as August. Our long CHF/NZD position was offside in this environment. Our conviction on this trade has fallen given the hawkish shift from the RBNZ, but we recommend holding onto this trade, as a reset in global asset prices could increase currency volatility and hurt the pair. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2   Data out of Canada this week has been robust: The employment report was stellar. 231K new jobs were added in June. The unemployment rate fell from 8.2% to 7.8%. The participation rate also increased from 64.6% to 65.2%. The BoC kept interest rates on hold at 0.25% but cut its weekly asset purchases from C$3 billion to C$2 billion. The Bloomberg Nanos Confidence index held steady at 66.4. The CAD fell by 0.2% this week and was flat on the announcement. The loonie has softened since the bottom in the DXY index, as overbought conditions are being worked off. There was no new information out of the recent BoC meeting – the central bank is on pace to start lifting rates ahead of the Fed as long as Canada approaches full employment and inflation remains above target. This will limit downside on the CAD. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2   The was scant data out of Switzerland this week: Producer prices rose by 2.9% year on year in June. Total sight deposits were unchanged at CHF 712 bn for the week of July 9. The Swiss franc was down 0.3% this week, after a nice run-up last week. Falling yields will continue to improve the relative appeal of the franc, like the yen. The franc will also benefit from safe-haven inflows if equity markets correct. We are long the CHF/NZD cross on this basis and are sticking with this recommendation. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2   Data out of Norway is improving: June CPI came in at 2.9% as expected. Underlying CPI was also 1.4%. PPI came in at 37.1% year on year in June, driven by high oil prices. The trade balance improved from NOK 15.5bn to NOK 25bn in June. The NOK was down by 1.7% this week against the dollar. We have a limit-buy on the Scandinavian currencies at -1.4% from current levels, on expectation that the sell-off is short lived. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2   Recent data from Sweden have been somewhat soft: Headline CPI fell from 1.8% in May to 1.3% in June. The core measure also fell from 2.1% to 1.6% but was better than expectations. The core core measure came in at 0.9% as expected. The SEK was the weakest G10 currency this week, falling by 0.7%. A disappointment in Swedish inflation is a surprise, given the inflationary overshoots we are seeing elsewhere. As Sweden is a small, open economy, inflation there will pick up (via imported inflation), which will lift expectations that the Riksbank will normalize policy. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020   Footnotes 1The theory was proposed by Stephen Jen, a former IMF economist and now a hedge fund manager at Eurizon SLJ Capital in London. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle.  Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing.  For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chinese Economy Is Slowing, But Not Too Slow Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Demand Not As Soft Compared With Production Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Slow Recovery In Services Largely Due To Lingering COVID Effects Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Producer Prices Remain Elevated Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market.    Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Housing Market Mania Remains Authorities' Pressure Point Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle.  Why Now? Chart 7More 'Pain' Needed For Broad Easing More 'Pain' Needed For Broad Easing More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9).   Chart 8SMEs Under Elevated Pricing Stress SMEs Under Elevated Pricing Stress SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels The PBoC Has Kept Rates At Historic Low Levels The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates Bank Lending Rates Have Not Declined With Policy Rates Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs China’s Monetary Policy: Easy, But Not Easing China’s Monetary Policy: Easy, But Not Easing Chart 12Waning SMEs' Demand For Bank Credit Waning SMEs' Demand For Bank Credit Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit Numbers In June Beat Market Expectations Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation China’s Monetary Policy: Easy, But Not Easing China’s Monetary Policy: Easy, But Not Easing Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Credit Growth Lags RRR Cuts By About Two Quarters Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Negative Credit Impulse In 2021 Relative To 2020 Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21 The Credit Structure, Rather Than Volume, Will Improve In 2H21 The Credit Structure, Rather Than Volume, Will Improve In 2H21   Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18).  Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Limited Upsides For Corporate Bond Issuance In 2H21 Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese Stock Prices Failed To Break Out Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio.  Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again.  Chart 21Long Lags Between First RRR Cut And Stock Market Troughs Long Lags Between First RRR Cut And Stock Market Troughs Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It Takes More Than One RRR Cut To Start A Bond Market Bull Run It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations

Highlights The US dollar will reach its ultimate high in the next deflationary shock. The swing factor for dollar demand is portfolio flows. In the next shock, portfolio flows will surge into US investments, driving up the US dollar to its ultimate high. One reason is that the US T-bond is the only major bond that can act as a haven-asset, now that most other bond yields are close to the effective lower bound. For US investors, international stocks will create a double-jeopardy. Not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. For non-US investors, the US 30-year T-bond will create a double-win from price surge and dollar surge, leading to a potential doubling of your money. Fractal trade shortlist: stocks versus bonds, tin, and US REITS versus US utilities. Feature Chart of the WeekSuccessive Shocks Take The Dollar To New Highs Successive Shocks Take The Dollar To New Highs Successive Shocks Take The Dollar To New Highs In our recent report The Shock Theory Of Bond Yields we explained that the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that an economy has endured. Each successive deflationary shock takes the bond yield to a lower low. Until it can go no lower (Chart 2). Chart I-2Successive Shocks Take The T-Bond Yield To New Lows Successive Shocks Take The T-Bond Yield To New Lows Successive Shocks Take The T-Bond Yield To New Lows Today’s report explains an important corollary. Each major deflationary shock has taken the US dollar to a new high, led by strong rallies against cyclical currencies such as the pound and the Canadian dollar (Chart of the Week, Chart I-3 and Chart I-4). We conclude that the US dollar will reach its ultimate high in the next deflationary shock. Chart I-3USD/GBP Surges In Shocks USD/GBP Surges In Shocks USD/GBP Surges In Shocks Chart I-4USD/CAD Surges In Shocks USD/CAD Surges In Shocks USD/CAD Surges In Shocks   Investors Must Build Shocks Into Their Strategy Most strategists claim that shocks, such as the pandemic, are inherently unpredictable. They argue that shocks are exogenous events that investors cannot plan for. We disagree. Granted, the timing and source of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the likelihood of suffering a shock is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or to slump by at least 25 percent.1 Using this definition through the past five decades, shocks have arrived with a remarkable predictability (Chart I-5). As a statistical distribution, the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). Chart I-5A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years Hence, in any three-year period, the likelihood of suffering a shock is 50 percent; in a five-year period, it is 81 percent; and in a ten-year period, it is a near-certain 96 percent (Chart I-6). Chart I-6On A Multi-Year Horizon, A Shock Is A Near-Certainty Why The Dollar’s Ultimate High Is Yet To Come Why The Dollar’s Ultimate High Is Yet To Come Yet, to repeat, the precise source and timing of the near-certain shock is unknown. This creates a dissonance for our narrative-focused minds. Absent a narrative for the certain shock, we do not plan for it. But we should. For long-term investors one crucial takeaway is that the ultimate low in the T-bond yield is yet to come. Another crucial takeaway is that the ultimate high in the US dollar is also yet to come. In A Shock, The US Dollar Surges The net demand for dollars comes from four sources: To fund the demand for goods and services denominated in dollars. (In fact, the structural US deficit in goods and services means that this source generates a persistent supply of dollars.) To fund the demand for long-term investments denominated in dollars, also known as foreign direct investment (FDI). To fund the demand for shorter-term financial investments like bonds and equities denominated in dollars, also known as portfolio flows.2 To fund the demand for currency reserves denominated in dollars. Of these four sources of dollar demand, the US deficit in goods and services is not particularly volatile. FDI flows also change relatively slowly. Meanwhile, demand for dollar reserves is a residual factor, except at the rare moment that a currency peg starts or ends.3  The largest quarterly swings in portfolio flows swamp the largest quarterly swings in the trade balance and FDI. This means that the swing factor for dollar demand is portfolio flows. Chart I-7 and Chart I-8 show that the largest quarterly swings in portfolio flows, at over $1.5 trillion (annualised rate) swamp the largest quarterly swings in the trade balance and FDI, at just $0.5 trillion. Chart I-7The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows Chart I-8The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows All of which brings us to the main point of this report. In a shock, portfolio flows surge into US investments, which drives up the US dollar. In a shock, portfolio flows surge into US investments, which drives up the US dollar. There are two reasons for this. First, the US stock market is one of the most defensive in the world. Hence, in a shock, equity flows flood into the US (Chart I-9). Chart I-9The US Stock Market Is One Of The Most Defensive In The World The US Stock Market Is One Of The Most Defensive In The World The US Stock Market Is One Of The Most Defensive In The World But even more important now, the US T-bond is the only major bond that can act as a haven-asset. With most other bond yields already close to the effective lower bound, the US T-bond is the only mainstream asset which still has substantial scope to rally when other asset prices are collapsing. Hence, in recent years, the dollar is just tracking the performance of bonds versus stocks (Chart I-10). It follows that in the next deflationary shock, when bonds surge versus stocks, the dollar will surge to its ultimate high. Chart I-10The Dollar Is Just Tracking Bonds Versus Stocks The Dollar Is Just Tracking Bonds Versus Stocks The Dollar Is Just Tracking Bonds Versus Stocks An Inflationary Shock Will Quickly Morph Into A Deflationary Shock But what if the next shock is a dollar crisis? Such a crisis, caused by a loss of faith in the greenback as a store of value, would start off inflationary – to the detriment of the dollar. However, our high-conviction view is that even if the shock started as inflationary, it would quickly morph into deflationary. The simple reason is that the initial backup in bond yields that would come from such an inflationary shock would collapse the value of $500 trillion worth of global real estate, equities, and other risk-assets, and thereby unleash a massive deflationary impulse. Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. Investors demand a massive risk premium when inflation is out of control. The starting valuation needed to generate a given real return during an inflationary shock collapses because investors demand a massive risk premium when inflation is out of control. For example, in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But to generate the same real return of 10 percent during the inflationary 1970s, the starting multiple had to halve to 7 (Chart I-11). Chart I-11In An Inflationary Shock, Valuations Collapse In An Inflationary Shock, Valuations Collapse In An Inflationary Shock, Valuations Collapse Suffice to say, if the valuation of $500 trillion of global risk-assets were to halve, we would not have to worry about inflation. So, to sum up: On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise source or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a net deflationary shock or shocks into their long-term investment strategy. Specifically, in the next shock: US equities will outperform non-US equities. The 10-year T-bond yield will reach zero, and the 30-year T-bond yield will reach 0.5 percent. The US dollar will reach its ultimate high. This leads to two very important messages, one for US investors, one for non-US investors. For US investors, international stocks will create a double-jeopardy. In the next shock, not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. The corollary for non-US investors is that the US 30-year T-bond will create a double-win. Not only will the T-bond price surge, but the dollar will also reach a new high. The combination will lead to a potential doubling of your money. H1 2021 Win Ratio Reaches A Magnificent 71 Percent Last Thursday’s 16 percent rally in Nike shares on a brighter sales outlook means that our long Nike versus L’Oréal trade quickly achieved its 9 percent profit target. Long USD/HUF also quickly achieved its 3 percent profit target. Combined with other ‘wins’, this has boosted the fractal trades win ratio for H1 2021 to a magnificent 71 percent – comprising 12.1 wins versus just 4.9 losses. A fragile fractal structure is a warning that the investors setting the investment’s price has become dangerously biased to short-term traders. As longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. This creates an excellent countertrend investment opportunity because once the longer-term investors re-enter the price setting process, the recent trend will reverse. This week we highlight three fragile fractal structures. The fractal structure of stocks versus bonds (MSCI All Country World versus 30-year T-bond) remains fragile, suggesting that a neutral stance, at best, for stocks versus bonds through the summer (Chart I-12). Chart I-12The Fractal Structure Of Stocks Versus Bonds Is Fragile The Fractal Structure Of Stocks Versus Bonds Is Fragile The Fractal Structure Of Stocks Versus Bonds Is Fragile The fractal structure of tin is also fragile (Chart I-13). Given that most commodity prices have begun corrections, tin is vulnerable – especially versus other commodities. Chart I-13The Fractal Structure Of Tin Is Fragile The Fractal Structure Of Tin Is Fragile The Fractal Structure Of Tin Is Fragile Finally, comparing two high-yielding sectors, the fractal structure of US REITS versus US utilities is at a point of fragility that has reliably presaged countertrend moves (Chart I-14). Accordingly, this week’s recommended trade is to short US REITS versus US utilities, setting the profit target and symmetrical stop-loss at 5 percent. Chart I-14Short US REITS Versus US Utilities Short US REITS Versus US Utilities Short US REITS Versus US Utilities   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 In this discussion, portfolio flows include short-term speculative flows. 3For example, if a currency broke its peg with the dollar it would stop buying the dollar reserves needed to maintain the peg. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart I-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart I-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

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

Dear Client, Next week, instead of our regular report, we will be sending you a Special Report from BCA Research’s MacroQuant tactical global asset allocation team. Titled “MacroQuant: A Quantitative Solution For Forecasting Macro-Driven Financial Trends,” this white paper will discuss the purpose, coverage, and methodology of the MacroQuant model. I hope you will find the report insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets for the rest of 2021 and beyond. We will also be holding a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) to discuss the outlook. Best regards, Peter Berezin Chief Global Strategist Highlights Although the Fed delivered a hawkish surprise on Wednesday, monetary policy is likely to remain highly accommodative for the foreseeable future. We continue to see high US inflation as a long-term risk rather than a short-term problem. Outside of a few industries, wage inflation remains well contained. In those industries suffering from labor shortages, the expiration of emergency unemployment benefits, increased immigration, and the opening up of schools should replenish labor supply. Bottlenecks in the global supply chain are starting to ease. Many key input prices have already rolled over, suggesting that producer price inflation has peaked and is heading down. A slowdown in Chinese credit growth could weigh on metals prices during the summer months, which would further temper inflationary pressures. We are downgrading our view on US TIPS from overweight to neutral. Owning bank shares is a cheaper inflation hedge. Look Who’s Talking The Fed jolted markets on Wednesday after the FOMC signaled it may raise rates twice in 2023. Back in March, the Fed projected no hikes until 2024 (Chart 1). Chart 1Fed Forecasts Converge Toward Market Expectations Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Seven of 18 committee members expected lift-off as early as 2022, up from four in March. Only five participants expected the Fed to start raising rates in 2024 or later, down from 11 previously. The Fed acknowledged recent upward inflation surprises by lifting its forecast of core PCE inflation to 3.4% for 2021 compared with the March projection of 2.4%. These forecast revisions bring the Fed closer to market expectations, although the latter are proving to be a moving target. Going into the FOMC meeting, the OIS curve was pricing in 85 bps of rate tightening by the end of 2023. At present, the market is pricing in about 105 bps of tightening. At his press conference, Chair Powell acknowledged that FOMC members had discussed scaling back asset purchases. “You can think of this meeting as the ‘talking about talking about’ meeting,” he said. A rate hike in 2023 would imply the start of tapering early next year. The key question for investors is whether this week’s FOMC meeting marks the first of many hawkish surprises from the Fed. We do not think it does. As Chair Powell himself noted, the dot-plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” Ultimately, a major monetary tightening cycle would require that inflation remain stubbornly high. As we discuss below, while there are good reasons to think that the US economy will eventually overheat, the current bout of inflation is indeed likely to be “transitory.” This implies that bond yields are unlikely to rise into restrictive territory anytime soon, which should provide continued support to stocks. Inflation: A Long-Term Risk Rather Than A Short-Term Problem Chart 2Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago There are plenty of reasons to worry that US inflation will eventually move persistently higher. As we discussed in a recent report, many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 2). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over unruly global supply chains. Baby boomers are leaving the labor force en masse. As a group, baby boomers control more than half of US wealth (Chart 3). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Chart 3Baby Boomers Have Accumulated A Lot Of Wealth Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Despite a pandemic-induced bounce, underlying productivity growth remains disappointing (Chart 4). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 5). Chart 4Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Chart 5Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Perhaps most importantly, policymakers are aiming to run the economy hot. A tight labor market will lift wage growth (Chart 6). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Despite these structural inflationary forces, history suggests that it will take a while – perhaps another two-to-four years – for the US economy to overheat to the point that persistently higher inflation becomes a serious risk. Consider the case of the 1960s. While the labor market reached its full employment level in 1962, it was not until 1966 – when the unemployment rate was a full two percentage points below NAIRU – that inflation finally took off (Chart 7). Chart 6A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In May, 4.4% fewer Americans were employed than in January 2020 (Chart 8). The employment-to-population ratio for prime-aged workers stood at 77.1%, 3.4 percentage points below its pre-pandemic level (Chart 9). Chart 8US Employment Still More Than 4% Below Pre-Pandemic Levels Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 9Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels A Labor Market Puzzle Admittedly, if one were to ask most companies if they were finding it easy to hire suitable workers, one would hear a resounding “no.” According to the National Federation of Independent Business (NFIB), 48% of firms reported difficulty in filling vacant positions in May, the highest share in the 46-year history of the survey (Chart 10). Chart 10US Labor Market Shortages (I) US Labor Market Shortages (I) US Labor Market Shortages (I) Chart 11US Labor Market Shortages (II) US Labor Market Shortages (II) US Labor Market Shortages (II)   Nationwide, the job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The share of workers quitting their jobs voluntarily – a measure of worker confidence – also hit a record of 2.7% (Chart 11). How can we reconcile the apparent tightness in the labor market with the fact that employment is still well below where it was at the outset of the pandemic? Four explanations stand out. First, unemployment benefits remain extremely generous. For most low-wage workers, benefits exceed the pay they received while employed. It is not surprising that labor shortages have been most pronounced in sectors such as leisure and hospitality where average wages are relatively low (Chart 12). The good news for struggling firms is that the disincentive to working will largely evaporate by September when enhanced unemployment benefits expire. Chart 12Labor Scarcity Prevalent In Low-Wage Sectors Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 13School Closures Have Curbed Labor Supply Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Second, lingering fears of the virus and ongoing school closures continue to depress labor force participation. Chart 13 shows that participation rates have recovered less for mothers with young children than for other demographic groups. This problem will also fade away by the fall when schools reopen. Third, the number of foreign workers coming to the US fell dramatically during the pandemic. State Department data show that visas dropped by 88% in the nine months between April and December of last year compared to the same period in 2019 (Chart 14). President Biden revoked President Trump’s visa ban in February, which should pave the way for renewed migration to the US. Chart 14US Migrant Worker Supply Is Depressed Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 15The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement   Fourth, about 1.5 million more workers retired during the pandemic than one would have expected based on the pre-pandemic trend (Chart 15). Most of these workers were near retirement age anyway. Thus, there will likely be a decline in new retirements over the next couple of years before the baby boomer exodus described earlier in this report resumes in earnest. Other Input Prices Set To Ease Just as labor shortages in a number of industries will ease later this year, some of the bottlenecks gripping the global supply chain should also diminish. The prices of various key inputs – ranging from lumber, steel, soybeans, corn, to DRAM prices – have rolled over (Chart 16). This suggests that producer price inflation for manufactured goods, which hit a multi-decade high of 13.5% in May – has peaked and is heading lower. Chart 16Input Prices Have Rolled Over Input Prices Have Rolled Over Input Prices Have Rolled Over The jump in prices largely reflected one-off pandemic effects. For example, rental car companies, desperate to raise cash at the start of the pandemic, liquidated part of their fleets. Now that the US economy is reopening, they have found themselves short of vehicles. With fewer rental vehicles hitting the used car market, households flush with cash, and new vehicle production constrained by the global semiconductor shortage, both new and used car prices have soared. Vehicle prices have essentially moved sideways since the mid-1990s (Chart 17). Thus, it is doubtful that the recent surge in prices represents a structural break. More likely, prices will come down as supply increases. According to a recent report from Goldman Sachs, auto production schedules already imply an almost complete return to January output levels in June. Chart 17Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Chart 18Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet As Chart 18 shows, more than half of the increase in consumer prices in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI remains below its pre-pandemic trend (Chart 19). Chart 19Unwinding Of "Base Effects" Unwinding Of "Base Effects" Unwinding Of "Base Effects"   Chart 20"Supercore" Inflation Measures Remain Well Contained "Supercore" Inflation Measures Remain Well Contained "Supercore" Inflation Measures Remain Well Contained More refined measures of underlying inflation such as the trimmed-mean CPI, median CPI, and sticky price CPI are all running well below their official core CPI counterpart (Chart 20). While certain components of the CPI basket, such as residential rental payments, are likely to exhibit higher inflation in the months ahead, others such as vehicle and food prices will see lower inflation, and perhaps even outright deflation. Slower Chinese Credit Growth Should Temper Commodity Inflation Chart 21Chinese Credit Growth And Metal Prices Move Together Chinese Credit Growth And Metal Prices Move Together Chinese Credit Growth And Metal Prices Move Together Chinese credit growth and base metals prices are strongly correlated (Chart 21). We do not expect the Chinese authorities to embark on a new deleveraging campaign. Credit growth has already fallen back to 11%, which is close to the prior bottom reached in late-2018. Nevertheless, to the extent that changes in Chinese credit growth affect commodity prices with a lag of about six months, metals prices could struggle to maintain altitude over the summer months. China’s plan to release metal reserves into the market could further dampen prices. We remain short the global copper ETF (COPX) relative to the global energy ETF (IXC) in our trade recommendations. The trade is up 18.4% since we initiated on May 27, 2021. We will close this trade if it reaches our profit target of 30%. Bank Shares Are A Better Hedge Against Inflation Than TIPS We have been overweight TIPS in our view matrix. However, with 5-year/5-year forward breakevens trading near pre-pandemic levels, any near-term upside for inflation expectations is limited (Chart 22). As such, we are downgrading TIPS from overweight to neutral in our fixed-income recommendations. Investors looking to hedge inflation risk should consider bank shares. Our baseline view is that the 10-year Treasury yield will rise to about 1.9% by the end of the year. If inflation fails to come down as fast as we anticipate, bond yields would increase even more than that. Chart 23 shows that banks almost always outperform the S&P 500 when bond yields are rising. Chart 22Limited Near-Term Upside For Inflation Expectations Limited Near-Term Upside For Inflation Expectations Limited Near-Term Upside For Inflation Expectations Chart 23Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment   Banks are also cheap. US banks trade at 12.2-times forward earnings compared with 21.9-times for the S&P 500. Non-US banks trade at 10-times forward earnings compared to 16.4-times for the MSCI ACW ex-US index. Finally, we like gold as a long-term inflation hedge. We would go long gold in our structural trade recommendations if the price were to fall to $1700/ounce. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Special Trade Recommendations Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Current MacroQuant Model Scores Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Tightening Pressures... Tightening Pressures... Chart 1B… Everywhere ...Everywhere ...Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. The Surging CB Monitors... The Surging CB Monitors... Chart 2B… Suggest More Upside For Bond Yields ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising All BoE Monitor Components Are Rising All BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Inflation Components Lagging Inflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor The BoJ Monitor The BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected No Change In Policy Expected No Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD A Positive Story For The CAD A Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor The Norges Bank Monitor The Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor The SNB Monitor The SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Tightening Pressures... Tightening Pressures... Chart 1B… Everywhere ...Everywhere ...Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. The Surging CB Monitors... The Surging CB Monitors... Chart 2B… Suggest More Upside For Bond Yields ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? Is This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness Booming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced Not Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? Upside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising All BoE Monitor Components Are Rising All BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields BoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe Still Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Inflation Components Lagging Inflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message Markets Hear The ECB's Dovish Message   BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor The BoJ Monitor The BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan Deflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components Modest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected No Change In Policy Expected No Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Canadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD A Positive Story For The CAD A Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced Canadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Growth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia Markets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack The New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices The RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Markets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... The Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth ...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank The OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor The Norges Bank Monitor The Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway Inflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates The Norges Bank Should Hike Rates The Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor The SNB Monitor The SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Swiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland Growth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Could The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight BCA Central Bank Monitor Chartbook: The Long Kiss Goodnight Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com.