Monetary Policy

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage Global Semiconductor Shortage Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 8Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls German Conservatives Waver in Polls German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 11Germany Puts Multilateralism To The Test Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 12UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues see Danny Crichton, Chris Miller, and Jordan Schneider, "Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors," Foreign Policy Research Institute, March 2021, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Thursday, March 25 at 10:00 am EDT and Friday March 26 at 9:00 am HKT. I look forward to your comments and questions during the webcast. Best regards, Chester Highlights During bear markets, counter-trend rallies in the dollar are capped around 4%. This time should be no different. Meanwhile, unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real short rates will drop. The relative equity performance of the US is critical for the dollar. Reserve diversification out of dollars has also started to place a natural ceiling against other developed market currencies. An attractive opportunity is emerging to short the AUD/CAD cross. Feature The 1.7% rise in the US dollar this year is reinvigorating the bull case. When presenting our key views last year, we highlighted that the DXY index was at risk of a 2-4% bounce.1 We reaffirmed this view in our January report: Sizing A Potential Dollar Bounce. At the time, the DXY index was at the 90 level, suggesting the rally should fizzle around 94. Therefore, the key question is whether the nascent rise in the DXY will punch through this level, or fade as we originally expected. The short-term case for the dollar remains bullish. The currency is much oversold. Meanwhile, real interest rates are moving in favor of the US, vis-à-vis a few countries. Third and interrelated, economic momentum in the US is quite strong, compared to other G10 countries. With the rising specter of a market correction, the dollar could also benefit from safe haven flows towards the US. The Federal Reserve’s meeting yesterday certainly reaffirmed that short-term rates will remain anchored near zero, at least until 2023. The Fed does not see inflation much above 2% a couple of years out. Nevertheless, a lot can change in the coming months. Cycles, Positioning And Interest Rates The dollar tends to move in long cycles, with the latest bull and bear markets lasting about a decade or so. In other words, the dollar is a momentum currency. As such, determining which regime you are in is critical to assessing the magnitude of any rally. This is certainly the case when sentiment remains overly dollar bearish, as now. During bear markets, counter-trend rallies in the dollar are capped around 4-6%. This was what happened in the early 2000s. In bull markets, such as after the financial crisis, the dollar achieves escape velocity, with more durable rallies well into the teens (Chart I-1). So far, the current rise still fits within the narrative of a healthy reset in a longer-term bear market. Chart I-1The Dollar Rally Is Still Benign The Dollar Rally Is Still Benign The Dollar Rally Is Still Benign Long interest rates have also been moving in favor of the dollar, especially relative to the euro area, Japan, and even Sweden. Currencies are driven by real interest rate differentials, and higher US yields are bullish. With the Fed giving no indication it will prevent the curve from steepening further, US interest rates could keep gaping higher. However, currencies are about relative rate differentials, and the rise in US interest rates has not been in isolation. Rates in the UK, Australia and New Zealand, countries that have managed the COVID-19 crisis pretty well, are beginning to rise faster than in the US (Chart I-2). Chart I-2A Synchronized Rise In Global Yields A Synchronized Rise In Global Yields A Synchronized Rise In Global Yields US Versus World Growth The rise in US interest rates has been justified by better economic performance. Whether looking at purchasing managers’ indices, economic surprise indices, or even GDP growth expectations, the US has had the upper hand (Chart I-3). The Fed expects US growth to hit 6.5% this year. This is well above what other central banks expect for their domestic economies. The ECB expects 4%, the BoJ expects 3.9%, and the BoC expects 4.6% (Table I-1). Chart I-3AThe US Leads In Growth This Year The US Leads In Growth This Year The US Leads In Growth This Year Chart I-3BThe US Leads In Growth This Year The US Leads In Growth This Year The US Leads In Growth This Year Table I-1The US Leads In Growth And Inflation This Year Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears However, economic dominance can be transient, especially in a world of flexible exchange rates.  For one, a higher dollar will sap US growth via the export channel. This is especially the case since the starting point is an expensive currency. On a real effective exchange rate basis, the dollar is above its long-term mean (Chart I-4). Meanwhile, we expect the rest of the world to perform better as economies reopen. The services PMI in the US is already close to a cyclical high, similar to Sweden (Chart I-5). These are among the countries with the least stringent COVID-19 measures in the western hemisphere. This suggests that other economies, even manufacturing-centric ones, could see a coiled-spring rebound in growth as we put this pandemic behind us. Chart I-4The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-5The US Service PMI Is At A Cyclical High The US Service PMI Is At A Cyclical High The US Service PMI Is At A Cyclical High The sweet spot for most economies is when growth is rising but inflation is low, allowing the resident central bank to keep policy dovish. However, it is an open question if the US can continue to boost spending, without a commensurate rise in inflation. The OECD estimates that the US output gap will close by 2022, with the $1.9-trillion fiscal package. This will put the US well ahead of any G10 country (Chart I-6). Unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real rates will drop (Chart I-7). Rising nominal rates and falling real yields will be anathema to the dollar. Chart I-6The US Output Gap Will Soon Close The US Output Gap Will Soon Close The US Output Gap Will Soon Close Chart I-7Wages And Inflation Should Inch Higher Wages And Inflation Should Inch Higher Wages And Inflation Should Inch Higher Equity Rotation And The Dollar A currency manager once noted that the most important variable to pay attention to when making FX allocations is relative equity performance. This might seem bizarre at first blush, but stands at the center of what an exchange rate is – a mechanism that equalizes rates of return across countries. As such while bond flows are important for exchange rates, equity flows matter as well. The relative equity performance of the US is critical for two reasons. First, the US equity market tends to do relatively better during bear markets. This was the case last year and during the 2008 crisis. Second, the outperformance of the US over the last decade has dovetailed with a dollar bull market (Chart I-8). It is rare to find a currency that has performed well both during equity bull and bear markets. If past is prologue, the near-term risks for the dollar are to the upside, especially if the market rally encounters turbulence as yields rise. The put/call ratio in the US is at a 5-year nadir. A move towards parity could violently pull up the DXY index (Chart I-9). However, a garden-variety 5-10% correction in the SPX should correspond to a shallow bounce in the DXY. This will also fit the pattern of bear market USD rallies, as we already highlighted in Chart I-1. Chart I-8US Equity Relative Performance And The Dollar US Equity Relative Performance And The Dollar US Equity Relative Performance And The Dollar Chart I-9The Dollar Could Rise In ##br##A Market Reset The Dollar Could Rise In A Market Reset The Dollar Could Rise In A Market Reset At the same time, any correction could usher in a violent rotation from cyclicals to defensives, especially if underpinned by higher interest rates. The performance of energy and financials are a leap ahead of other sectors in the S&P 500 this year. Importantly, they also massively outperformed during the February drawdown. Meanwhile, valuations are heavily elevated in the US compared to the rest of the world. This is true for growth sectors compared to value, and cyclicals compared to defensives. Throughout history, both exchange rates and valuations have tended to mean revert. Long-Term Dollar Outlook The 2020 pandemic was a one-in-a-hundred-year event. Coordinated fiscal and monetary stimuli have ushered in a new economic cycle. As a counter-cyclical currency, the dollar tends to do poorly (Chart I-10). This is because monetary stimulus provides more torque to economies levered to the global cycle. Once growth achieves escape velocity, the currencies of these more pro-cyclical economies benefit. The IMF projects that non-US growth should outpace US growth after 2021. Meanwhile, it is an open question that any rally in the dollar will be durable. The key driver behind the dollar increase in 2020 was a global shortage. Not only has the Fed extended its liquidity provisions to foreign central banks until September this year, the share of offshore US dollar debt issuance has fallen by a full 9 percentage points (Chart I-11). Simply put, the Fed is flooding the system with dollar liquidity at the same time that foreign entities are weaning themselves off it Chart I-10The IMF Expects Faster Growth Outside The US After 2021 The IMF Expects Faster Growth Outside The US After 2021 The IMF Expects Faster Growth Outside The US After 2021 Chart I-11Share Of US Dollar Debt ##br##Rolling Over Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears The reason behind this is balance-of-payment dynamics. The market has realized that ballooning twin deficits in the US come at a cost. For foreign issuers, it is the prospect of rolling over US-denominated debt at a much higher coupon rate. For bond investors, it is currency depreciation, especially if fiscal largesse becomes too “sticky,” and stokes inflation. As such, bond investors continue to avoid the US, despite rising rates (Chart I-12). Finally, reserve diversification out of dollars has started to place a natural ceiling on the US dollar, especially against other developed market currencies. Ever since the trend began to accelerate in 2015, the DXY has been unable to sustainably punch through the 100 level (Chart I-13). This will place a durable floor under developed market currencies in general and gold in particular. The Chinese RMB has also been gaining traction in global FX reserves. Chart I-12Little Appetite For US ##br##Treasurys Little Appetite For US Treasurys Little Appetite For US Treasurys Chart I-13Reserve Diversification Has Been A Headwind For The Dollar Reserve Diversification Has Been A Headwind For The Dollar Reserve Diversification Has Been A Headwind For The Dollar More specifically, the role of the USD/CNY exchange rate as a key anchor for emerging market currencies will rise, especially if the RMB remains structurally strong.2 The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. Swap agreements entail no exchange of currency, but are about confidence. The PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves. The dollar will remain the global reserve currency for years to come. However, a slow pivot towards reserve diversification will act as a structural headwind for the dollar. Housekeeping Chart I-14AUD/CAD Is Correlated To The VIX Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears We were stopped out of our CAD/NOK trade for a profit of 3.1%. The resilience of the US economy is benefiting the CAD more than the NOK for now. However, the Norges Bank confirmed it might be one of the first central banks to lift rates, as early as this year. We are both short USD/NOK and EUR/NOK and recommend sticking with these positions. Second, the growing spat between the EU and the UK could lead to more volatility in our short EUR/GBP position. Our target remains 0.8, but we are tightening stops to 0.865 to protect profits. The BoE left interest rates unchanged, but struck a constructive tone. This will bode well for cable, beyond near-term volatility. Third, our short USD/JPY position was stopped out amid the dollar rally. We are standing aside for now, but will reopen this trade later. Finally, a rise in volatility will boost the dollar, but also benefit short AUD/CAD positions. We are already short the AUD/MXN, but short AUD/CAD could be more profitable should market turmoil persist (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see the Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020. 2 Please see Foreign Exchange Strategy Currency In-Depth Report, titled “Will The RMB Continue To Appreciate?,” dated February 26, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Most data out of the US has been robust: Both PPI, import and export prices were in line with expectations for February. The PPI ex food and energy came in at 2.5% year-on-year. Empire manufacturing was robust at 17.4 in March, versus 12.1 last month. Housing starts and building permits came in a nudge below expectations in February, at 1421K and 1682K. The one disappointment was retail sales, which fell 3.3% year-on-year in February. The DXY index rose slightly this week. The FOMC remained dovish, without any revision to its median path of interest rate hikes. The markets disliked its reticence on rising long-bond yields. As such, equities are rolling over as yields continue to creep higher. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 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 Recent data from the euro area are mending: The ZEW expectations survey rose to 74 in March, from 69.6. For Germany, the improvement was better at 76.6 from 71.2. The trade balance remained at a healthy €24.2bn euro surplus in January. The euro fell by 0.6% amidst broad dollar strength. With the ECB committed to cap the rise in yields and rise in peripheral spreads, relative interest rates will move against the euro. Sentiment remains elevated, and so a healthy reset is necessary to wash out stale longs. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been mixed: Core machinery orders grew 1.5% year-on-year in January. Exports fell by 4.5% in January, while imports rose by 11.8%. This has shifted the adjusted trade balance to a deficit of ¥38.7bn yen. The Japanese yen fell by 0.4% against the US dollar this week, and remains the weakest G10 currency this year. Rising yields have seen Japanese investors stampede into overseas markets such as the UK, while pushing down the yen. We remain yen bulls, but will stand aside for now since it could still go lower in the short term. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been weak: Industrial production and construction output fell by 4.9% and 3% year-on-year in January. Monthly GDP growth fell by 2.9% in January. Rightmove house prices rose 2.7% year-on-year in March. The pound fell by 0.4% against the dollar this week. It however remains the best performing currency this year. The BoE kept monetary policy on hold, but struck a hawkish tone as vaccination progresses, giving way to higher mobility in the summer. We remain long sterling via the euro. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia was robust: Home prices rose by 3.6% in the fourth quarter. Modest home appreciation is welcome news by the RBA, given high-flying prices in its antipodean neighbor. The employment report was solid. There were 88.7K new jobs in February, all full-time. This pushed down the unemployment rate to 5.8% from 6.4%. The Aussie fell by 0.4% this week. The Australian recovery is fast approaching escape velocity, forcing the RBA to contain a more pronounced rise in long-bond yields. We remain long AUD/NZD. In the very near term, a market shakeout could pull the Aussie lower, favoring short AUD/CAD positions.  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 Recent data out of New Zealand was weak: Credit card spending fell by 10.6% year-on-year in January. Q4 GDP contracted by 1% both year-on-year and quarter-on-quarter. The current account remains in deficit at NZ$-2.7bn for Q4. The New Zealand dollar fell by 0.9% against the US dollar this week. The new rule to include house prices in setting monetary policy will be a logistical nightmare for the RBNZ. In trying to achieve financial stability, the RBNZ will have to forego some economic stability, especially if the country still requires accommodative settings. Confused messaging could also introduce currency volatility. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 There was a data dump in Canada this week: The economy added 259.2K jobs in February. This pushed down the unemployment rate from 9.4% to 8.2%. Wages also increased by 4.3% in February. The Nanos confidence index rose from 60.5 to 62.7 in the week of March 12. Housing starts rose by 246K in February, as expected. The BoC’s preferred measures of CPI came in close to the 2% target. Headline CPI was weaker at 1.1% in February. The Canadian dollar rose by 0.3% against the US dollar this week. The correction in oil prices could set the tone for the near-term performance of the loonie, despite robust domestic conditions. However, at the crosses, CAD should have upside. We took profits on our short CAD/NOK position this week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 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 There was scant data out of Switzerland this week: Producer and import prices fell by 1.1% year-on-year in February. February CPI releases also suggest the economy remains in deflation. The Swiss franc fell by 0.4% against the US dollar this week. Safe-haven currencies continue to be sold as yields rise, making the Swiss franc the worst performing currency this year after the yen. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors to stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The trade balance remained in surplus of NOK 25.1bn in February. The Norges bank kept interest rates on hold at 0%. The NOK fell by 1.2% against the dollar this week. The trigger was the selloff in oil prices. However, with the Norges bank signaling a rate hike later this year, placing it ahead of its G10 peers, there is little scope for the NOK to fall durably. Inflation in Norway is above target, and higher mobility later this year will benefit oil-rich Norway. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data releases were a slight miss: Headline CPI came in at 1.4% in February. Core CPI came in at 1.2%. The unemployment rate remained at 8.9% in February. The Swedish krona fell by 0.8% against US dollar this week. Sweden is struggling to contain another wave of the pandemic and this has weighed on the currency this year. The saving grace for the economy has been a global manufacturing cycle that continues humming. Until Sweden is able to get past the pandemic, the currency will continue trading in a stop-and-go pattern. We remain long the SEK on cheap valuations and as a play on the global industrial cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 1Biden’s Tax Hike Proposals On The Campaign Trail Building Back … The Wall Of Worry Building Back … The Wall Of Worry Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) Building Back … The Wall Of Worry Building Back … The Wall Of Worry For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening Building Back … The Wall Of Worry Building Back … The Wall Of Worry The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark China Policy Overtightening Benchmark China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge Building Back … The Wall Of Worry Building Back … The Wall Of Worry China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China Building Back … The Wall Of Worry Building Back … The Wall Of Worry The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China EU Risk Averse On China EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce Building Back … The Wall Of Worry Building Back … The Wall Of Worry As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 4BGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling German Party Polling German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Building Back … The Wall Of Worry Building Back … The Wall Of Worry Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.

Highlights The report from last week’s National People’s Congress (NPC) indicates a gradual pullback in policy support this year. Fiscal thrust will be neutral in 2021, whereas the rate of credit expansion will be slightly lower compared with last year. China’s economy should run on its own momentum in the first half, before slowing to a benign and managed rate. Nonetheless, the risk of policy overtightening is nontrivial and could threaten the cyclical outlook on China’s economy and corporate profits. The recent price correction in Chinese stocks has not yet run its course. Moreover, equity prices in both onshore and offshore markets are breaching their technical resistance. We are downgrading our tactical (0 to 3 months) and cyclical (6 to 12 months) positions on Chinese stocks to underweight relative to global benchmarks. Feature China’s budget and key economic initiatives unveiled at last week’s NPC indicate that policy tightening will be gradual this year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li Keqiang’s work plan presented at the NPC’s annual plenary session in Beijing. However, investors have centered on the government’s plan to have a smaller policy push on growth in its budget compared with last year, fearing that economic and corporate profit rebound will disappoint. The Shanghai Composite Index dropped by 6% during the week when the NPC took place. In our view, the risks of a policy over-tightening in the next six months are high. As such, with this report we are downgrading our cyclical call on Chinese stocks to underweight within a global equity portfolio.      Reading Policy Tea Leaves China's growth trajectory since the middle of 2020 has given the government comfort in staying the course on policy normalization. The question is how much Chinese policymakers are willing to pull back support for the economy this year. Overall, the central government plans a smaller policy push in this year's budget and intends to let the economy run on its own steam. Further policy reflation is not in the cards unless a relapse in the economy threatens job creation. The NPC outlined a growth target “above 6%” for 2021 and did not set a numerical goal for the 14th Five-Year Plan from 2021 to 2025. However, de-emphasizing growth does not mean China has abandoned its GDP targets (Table 1). Indeed, in most years in the past two decades, China’s expansion in GDP has overshot objectives set at the NPC (Chart 1). Our baseline estimate is that real GDP will increase by 8% in 2021. Table 12021 Economic And Policy Targets National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Chart 1Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years   We also maintain our view that the rate of credit expansion will be reduced by 2 to 3 percentage points this year to about 11% annually, which is in line with nominal GDP growth (Chart 2). On the fiscal front, the target for a budget deficit was cut by less than half percentage point compared with last year. When taking into account both the government’s budgetary and fund expenditures, the broad-measure fiscal deficit will probably be around 8% of GDP (about the same as last year), which implies there will not be any fresh fiscal thrust in 2021 (Chart 3) Chart 2Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Chart 3Neutral Fiscal Thrust Neutral Fiscal Thrust Neutral Fiscal Thrust The pullback in fiscal impulse is larger than in 2010, 2014, and 2017, following the previous three fiscal expansionary cycles. However, the government's eased budget deficit target this year does not mean government expenditure growth will slow. Government revenues climbed sharply by the end of 2020 and will continue to improve this year (Chart 4). Higher revenues will allow more government spending while keeping the fiscal deficit within its objectives. Chart 4Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Chart 5A Small Reduction In ##br##LG Bond Quota National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Furthermore, the quota for local government special purpose bonds was reduced by only 2% from last year.  It should help to support a steady growth in China’s infrastructure investment (Chart 5). The data from January and February total social financing shows a noticeable improvement in corporate demand for bank loans, as well as the composition of bank loans. Corporate demand for medium- and long-term loans remains on a strong uptrend, which reflects an ongoing recovery in corporate profits and supports an optimistic view on capital investment in the months ahead (Chart 6). Chart 6More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity Bottom Line: The growth and budget targets set at this year’s NPC suggest only a modest pullback in policy support. Downside Risks To The Economy Chart 7Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Despite a relatively dovish tone from the NPC, investors should not be complacent about the risk of a policy-tightening overshoot, which could lead to disappointing economic and profit growth this year.  In most of the previous policy tightening cycles, China’s economic activities remained resilient in the first 6 to 9 months (Chart 7). One exception was 2014, when nominal GDP growth dropped sharply as soon as credit growth slowed. The reason is that Chinese authorities kept a very disciplined fiscal stance and aggressively tightened monetary policy, while allowing the RMB to soft peg to a rising USD. In other words, macroeconomic policies were too restrictive during the 2013/14 cycle. Although messages from the NPC do not suggest that Chinese authorities are on such an aggressive tightening path this year, investors should watch the following signs that could threaten China's cyclical economic health: Policymakers may keep monetary conditions too tight, by allowing the RMB to rise too fast while lifting bank lending and policy rates. Currently rates are maintained at historically low levels, much lower than in previous policy tightening cycles (Chart 8). However, the trade-weighted RMB has appreciated by 6% since its trough in July last year and has returned to its pre US-China trade war level (Chart 9).  The Chairman of China’s Banking and Insurance Regulatory Commission recently signaled that bank lending rates would climb. Although we do not expect the rate to return to its 2014 or 2017 level, China is much more indebted than in previous cycles. Even a small bump in interest rates will place a burden on corporates and local governments’ debt servicing cost, dampening their propensity to invest (Chart 10).  Chart 8Aggressive Rate Hikes Are ##br##Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Chart 9Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Chart 10Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chart 11Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive   Policies could become too restrictive in key old-economy industries. Chinese authorities have reiterated their determination to contain price bubbles in the property sector. For the first time since 2017, bank lending to real estate developers grew at a pace far below overall bank loans and continued to trend downward in February this year (Chart 11). Moreover, household mortgage loans have reached their slowest expansion rate since 2013.  At 22% of China’s total bank lending, a sharp setback in the property sector’s loan growth will be a significant drag on total credit and the economy.   A worsened imbalance in supply and demand could lead to too much buildup in industrial inventory. Manufacturing inventories recovered sharply following last year’s massive stimulus and many sectors have surpassed their pre-pandemic levels (Chart 12). Strong external demand helped to boost China’s production and propensity to restock on raw materials. However, both China’s core CPI and producer prices for consumer goods remain in the doldrums, which indicates that domestic final demand has yet to fully recover (Chart 13).  As discussed in last week’s report, reopening the world economy in 2H21 should benefit the service sector more than tradeable goods. China’s inventory buildup, particularly in the upstream industries, could turn excessive when export growth slows and domestic demand fails to pick up the slack. Chart 12How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? Chart 13Final Demand Remains ##br##Weak Final Demand Remains Weak Final Demand Remains Weak The service sector could take longer than expected to recuperate, even though China’s domestic COVID-19 situation is under control. China’s services sector has flourished in recent years and accounted for 54% of the nation’s pre-pandemic economic output. However, about half of the service sector output is tied to real estate and financial services. Increasing pressures from tighter policy regulations targeting both the property and online financial service sectors could dampen their support to the economy more than policymakers anticipated. At the same time, wage and household income growth could remain tame by China’s standards (Chart 14).   The NPC’s targeted 7% annual increase in spending for national research and development – far below the 12% annual average reached during the past five years – will not be enough to offset the slowdowns in real estate and financial services (Chart 15). Chart 14Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Chart 15Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Bottom Line: The downside risks to China’s cyclical growth trajectory are nontrivial. A tug-of-war between policy tightening and growth support will likely persist throughout this year. Investment Implications We recommend investors to underweight Chinese stocks within a global equity portfolio, in the next 0 to 9 months (Chart 16A and 16B). Chart 16AChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chart 16BChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance On January 13, we tactically downgraded Chinese stocks from overweight to neutral, anticipating that China’s equity markets are sensitive to rising expectations of policy tightening, due to higher corporate debt-servicing costs and lofty valuations.  Chinese stock prices peaked in mid-February, but in our view the correction has not yet run its course. In terms of the economy, we maintain our baseline view that China's overall policy environment this year will be more accommodative than in 2017/18. The growth momentum carried over from last year's stimulus should prevent China's economy and corporate profits from slumping by too much this year. However, as policy supports are scaled back, investors will increasingly focus on the intensity of China’s domestic policy tightening and the uncertainties surrounding it. Downside risks are nontrivial and will continue to weigh on investors' sentiment. For investors that are mainly exposed to the Chinese domestic equity market, the near-term setbacks in the A-share market are taking some air out of Chinese equities' frothy valuations, and may pave the way for a more optimistic cyclical outlook beyond the next 9 to 12 months. We recommend domestic investors to stay on the sidelines for now, but will start recommending sector rotations in the next few months when opportunities arise. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights UK Interest Rates: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Implications for Gilts & GBP: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Maintain below-benchmark duration on Gilts, while downgrading UK allocations within dedicated global fixed income portfolios to neutral. The pound has upside in this environment, especially if depressed UK productivity starts to recover. Feature Chart 1UK Real Yields: Deeply Negative Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? The UK has become one of the more peculiar corners of the global fixed income universe. The outright level of longer-term Gilt yields is in the middle of the pack among the major advanced economies. The story is much different, however, when breaking those nominal UK yields into the real and inflation expectations components. The deeply negative real yields on UK inflation-linked Gilts are the lowest among the majors, even in a world where sub-0% real yields are prevalent in most countries (Chart 1). The flipside of that deeply negative real yield is a high level of inflation expectations. The breakeven inflation rate derived from the difference between the nominal and real 10-year Gilt yields is 3.3%, the highest in the developed “linkers” universe. Inflation expectations in UK consumer surveys are at similar levels, well above the 2% inflation target of the Bank of England (BoE), suggesting little confidence in the central bank’s ability or willingness to hit its own inflation goals. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy and Foreign Exchange Strategy, we investigate why UK real interest rates have remained so persistently negative and assess the possibility of a shift in the low interest rate regime in a post-Brexit, post-pandemic UK – a move that could be quite bearish for UK fixed income markets and bullish for the British pound. Can The BoE Ignore Cyclical Upward Pressure On UK Bond Yields? The UK has suffered from a series of shocks, starting with the 2008 crisis, that have limited the ability of the BoE to attempt to tighten monetary policy. The 2011/12 European debt crisis hurt the UK’s most important trading partners, while the 2016 Brexit vote began a multi-year process of uncertainty over the future of those trading relationships. The COVID-19 pandemic is the latest shock, triggering a recession of historic proportions. The UK economy contracted by -10% in 2020, the largest decline since “The Great Frost” downturn of 1709. UK bond yields collapsed in response as the BoE cut rates to near-0% and reinforced that easy stance with aggressive quantitative easing and promises to keep rates unchanged over at the next few years. Today, UK financial markets are waking up to a world beyond the current COVID-19 lockdowns. The UK is running one of the world’s most successful vaccination rollouts, with 23 million jabs, or 35 per 100 people, already having been administered. UK Prime Minister Boris Johnson recently unveiled a bold plan to fully reopen the UK economy from the current severe lockdowns by mid-year. The UK government’s latest budget called for additional spending measures over the next year, including maintaining the work furlough scheme that has supported household incomes during the pandemic. As a result, UK growth expectations have exploded higher. According to the Bloomberg consensus economics survey, UK nominal GDP growth is expected to surge to 8.4% over calendar year 2021, an annual pace not seen since 1990 (Chart 2). Nominal Gilt yields have begun to reprice higher to reflect those surging growth expectations, with the 5-year/5-year forward Gilt yield climbing 67bps so far in 2021. Real Gilt yields are also moving higher with the 10-year inflation-linked Gilt climbing 38bps year to date, providing additional interest rate support that has fueled a surge in the pound versus the dollar (bottom panel). Our own BoE Monitor - containing growth, inflation and financial variables that typically lead to pressure on the central bank to adjust monetary policy – is signaling a reduced need for additional policy easing (Chart 3). The momentum of changes in longer-maturity UK Gilts and the trade-weighted UK currency index are usually correlated to the ebbs and flows of the BoE Monitor. The latest surge higher in yields and the currency suggests that the markets are anticipating the type of recovery that will put pressure on the BoE to tighten. Chart 2A Growth-Driven Repricing Of Gilts & GBP A Growth-Driven Repricing Of Gilts & GBP A Growth-Driven Repricing Of Gilts & GBP Chart 3Gilts & GBP Sniffing Out A Less Dovish BoE? Gilts & GBP Sniffing Out A Less Dovish BoE? Gilts & GBP Sniffing Out A Less Dovish BoE? It may take a while to see the BoE turn more hawkish, however. The BoE has become one of least active central banks in the world over the past decade. After the BoE cut its official policy interest rate, the Bank Rate, by 500bps during the 2008 financial crisis and 2009 recession, rates were kept in a range between 0.25% and 0.75% for ten consecutive years. The BoE cut rates aggressively in response to the COVID-19 pandemic, lowering the Bank Rate in March 2020 from 0.75% to 0.1%, where it still stands. The BoE has used quantitative easing (QE) and forward guidance to try and limit movements in bond yields whenever cyclical surges in inflation could have justified tighter monetary policy. That has led to an extended period of a negative BoE Bank Rate, something not seen since the inflationary 1970s (Chart 4). Back then, the BoE was lagging the surge in UK inflation, but still hiking nominal interest rates. Today, the central bank is keeping nominal rates near 0% with much lower levels of inflation. Chart 4Over A Decade Of Negative Real UK Interest Rates Over A Decade Of Negative Real UK Interest Rates Over A Decade Of Negative Real UK Interest Rates Short-term interest rate markets are still pricing in a very slow response from the BoE to the current growth optimism. Only 36bps of rate hikes over the next two years are discounted in the UK overnight index swap (OIS) curve. This go-slow response is in line with the BoE’s guidance on future rate hikes which, similar to the language used by other central banks like the Fed, calls for no pre-emptive rate hikes before inflation has sustainably returned to the BoE target. That combination would be consistent with current forward market pricing on both short-term interest rates and inflation. Chart 5BoE Keeping Real Rates Well Below R* BoE Keeping Real Rates Well Below R* BoE Keeping Real Rates Well Below R* In Chart 5, we show the real BoE Bank Rate, constructed by subtracting UK core CPI inflation from the Bank Rate. We also show a forward real rate calculated using the forward UK OIS and CPI swap curves. The market-implied path of the real Bank Rate shows very little change over the next decade, with the real Bank Rate expected to average around -2.5%. This is far below the estimates of a neutral UK real rate (or “r-star”) of just under 2%, as calculated by the New York Fed or recent academic studies. The neutral UK real rate has likely dipped because of the pandemic. The UK Office For Budget Responsibility (OBR) estimates that there has been a long-term “scarring” of the UK economy from COVID-19 through supply-side factors like weaker investment spending, lower productivity growth and diminished labor force participation – equal to three percentage points of the level of potential GDP.1 The BoE estimates a smaller “scarring” of 1.75 percentage points of potential output, but coming with a 6.5% reduction in the size of the UK capital stock. While these are significant reductions in the supply-side of the UK economy, they are not enough to account for the 4.5 percentage point difference between pre-pandemic estimates of the UK r-star and the market-implied path of the real BoE Bank Rate over the next decade. The implication is that the markets are not expecting the BoE to deviate from its strategy of doing very little with interest rates, even as growth recovers from the pandemic shock. That can be seen in the recent upturn in UK inflation expectations that is evident in both market-implied and survey-based measures. Chart 6UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation The 5-year/5-year forward UK CPI swap rate now sits at 3.6%, not far off the 3.3% level of 5-10 year consumer inflation expectations from the latest YouGov/Citigroup survey (Chart 6). The fact that inflation expectations can remain so elevated at a time when headline CPI inflation is struggling to avoid deflation is striking. This indicates a belief that the BoE will do very little in the future to stop a booming UK economy that is expected to put sustained downward pressure on the UK unemployment rate over the next few years (bottom panel). This is from a relatively low starting point of the unemployment rate given the massive government support programs that have limited the amount of pandemic-related layoffs over the past year. The BoE should have reasons to be more concerned about a resurgence of UK inflation. In its latest Monetary Policy Report, the BoE published estimates showing that the entire collapse in UK inflation in 2020 was attributable to weaker demand for goods and services – especially the latter (Chart 7). This suggests that UK inflation could rebound by a similar amount as the UK economy reopens from pandemic lockdowns. According to the UK OBR, 21% of UK household spending is on items described as “social consumption”, like restaurants and hotels (Chart 8). This is a much larger proportion than seen in other major developed economies (excluding Spain) and explains why consumer spending plunged so much more dramatically in the UK during 2020 than in other countries. Chart 7Only A Temporary Drag On UK Inflation From COVID-19 Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? Chart 8UK Households More Focused On “Social Consumption” Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? If the UK pandemic-related restrictions are eased as planned over the next few months, the potential for a sharp snapback in UK consumer spending is significant. The BoE estimates that UK households now have £125bn of “excess” savings thanks to government income support and reduced spending on discretionary items like dining out and vacations. This is the fuel to support a rapid recovery in consumption over the next 6-12 months, especially as personal income growth will get a boost as furloughed workers begin returning to work (Chart 9). Chart 9UK Economy On The Mend UK Economy On The Mend UK Economy On The Mend Chart 10Big Boost To UK Growth From Housing & Government Spending Big Boost To UK Growth From Housing & Government Spending Big Boost To UK Growth From Housing & Government Spending A similar argument can be made for investment spending – the BoE estimates that UK businesses have amassed £100bn pounds of excess cash, and the latest reading on the BoE’s Agents' Survey of UK firms shows a slight increase after months of decline (bottom panel). With a Brexit deal with the EU finally reached at the start of 2021, UK businesses can also look to increase investment spending that had been delayed because of the years of Brexit uncertainty. The UK economy is already getting a boost from a recovery in the housing market fueled by low interest rates, high household savings and improving consumer confidence. Mortgage approvals have soared to the highest level since 2007, while house prices are now expanding at a 6.4% annual rate (Chart 10). Add it all up, and the economic momentum in the UK is positive and likely to accelerate further in the coming months as a greater share of the population becomes vaccinated. The BoE’s dovish policy stance is likely to appear increasingly inappropriate relative to accelerating UK growth and inflation trends over the next several months. Thus, on a cyclical basis, UK bond yields, both nominal and real, have more upside potential even after the recent increase. Bottom Line: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Structural Forces Keeping UK Interest Rates Low Are Fading Looking beyond the cyclical drivers, the structural factors that have held down UK interest rates in recent years are also starting to fade. The supply side of the UK economy has suffered because of Brexit uncertainty. The OECD’s estimate of potential UK GDP growth fell from 1.75% in 2015 to 1.0% in 2020 (Chart 11). This was mostly due to declining productivity growth – a consequence of years of very weak business investment. The 5-year annualized growth rate of real UK investment spending fell to -3% in 2020, a contraction only matched during the past 30 years after the 1992 ERM crisis and 2008 financial crisis. That plunge in investment coincided with almost no growth in UK labor productivity over that same 5-year window. Chart 11The Road To Faster Potential UK Growth Starts With Investment The Road To Faster Potential UK Growth Starts With Investment The Road To Faster Potential UK Growth Starts With Investment Slowing population growth also weighed on UK potential growth, slowing to the lowest level in 15 years in 2019 as immigration from EU countries to the UK fell sharply. COVID-19 also hurt immigration flows into the UK last year. The UK Office for National Statistics estimated that the non-UK born population in the UK fell by 2.7% between June 2019 and June 2020. Diminished potential GDP growth is a factor that would structurally reduce the equilibrium real UK interest rate. We are likely past the worst for that downward pressure on potential growth and real rates. Population growth should also stabilize as the UK borders open up again and pandemic travel restrictions are loosened. Measured productivity is already starting to see a cyclical recovery, while investment spending is likely to improve as cash-rich UK companies began to ramp up capital spending plans deferred by Brexit and COVID-19. While the process leading from faster investment spending into speedier productivity growth is typically slow, the key point is that the worst of downtrend is likely over. This is an important development that has implications for UK fixed income markets. When looking at an international comparison of real central bank policy rates within the developed economies, the UK has fallen into the grouping of countries with persistently negative policy rates, namely Japan, the euro area, Switzerland, Sweden and Norway (Chart 12). We have dubbed that group the “Secular Stagnation 5”, after the term made famous by former US Treasury Secretary Lawrence Summers describing a state where the “natural” real rate of interest (r-star) that equates savings with investment is structurally negative. Chart 12Does The UK Belong In The 'Secular Stagnation 5'? Does The UK Belong In The 'Secular Stagnation 5'? Does The UK Belong In The 'Secular Stagnation 5'? Does the UK belong in the “Secular Stagnation 5”? As a way to assess this, we made some comparisons of selected UK data with the same data for those five countries. When looking at potential GDP growth and population growth, the UK sits right in the middle of the range of those growth rates for the five countries (Chart 13). UK productivity growth has underperformed the others recently but, prior to the 2016 Brexit shock, UK productivity was also in the middle of the Secular Stagnation 5 range. Chart 13Brexit Became A Major Hit To UK Potential Growth Brexit Became A Major Hit To UK Potential Growth Brexit Became A Major Hit To UK Potential Growth Chart 14UK Economy Less Focused On Investment & Exports UK Economy Less Focused On Investment & Exports UK Economy Less Focused On Investment & Exports On other measures, the UK is nothing like those other countries. The UK’s economy is far less geared towards exports and investment (Chart 14) and is more tilted towards consumer spending. That can be seen most clearly when looking at the data on savings/investment balances. The UK continuously runs a current account deficit, as opposed to the persistent surpluses seen in the Secular Stagnation 5 (Chart 15). Put another way, the UK is not a “surplus” country that saves more than it invests on a structural basis, a condition that typically depresses real interest rates. Chart 15The UK Is Not A Surplus Country The UK Is Not A Surplus Country The UK Is Not A Surplus Country Chart 16Gilts Will Not Become A Low-Beta Market Gilts Will Not Become A Low-Beta Market Gilts Will Not Become A Low-Beta Market Based on these cross-country comparisons, it is unusual for the UK to have such persistently low real interest rates. This has implications for UK bond yields. Over the past few years, Gilts have been transitioning from a status as a “high yield beta” market – whose yield movements are more correlated to swings in the overall level of global bond yields. The lower beta markets are in countries like Germany, France and Japan – all members of the Secular Stagnation club (Chart 16). The UK does not appear to warrant a permanent membership in that low-yielding group, based on structural factors. That is evident when looking at how Gilt yields are rising even with the BoE absorbing an increasing share of the stock of outstanding Gilts (bottom panel). We conclude that the transition of the UK to a low-beta market is related to the Brexit uncertainty post 2016 and the pandemic shock that has hit the consumer-focused UK economy exceptionally hard – both factors that are set to fade over the next year. Bottom Line: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Investment Conclusions Chart 17Downgrade Gilts To Underweight Downgrade Gilts To Underweight Downgrade Gilts To Underweight Our assessment of the cyclical and structural drivers of UK interest rates leads us to the following conclusions on UK fixed income and currency strategy: Duration: Maintain a below-benchmark exposure to UK interest rate movements. Gilt yields will rise by more than is discounted in the forwards over the next 6-12 months (Chart 17), coming more through rising real yields as the UK economy continues its post-Brexit, post-pandemic recovery. Country Allocation: Downgrade strategic allocations to UK Gilts to neutral from overweight in dedicated fixed income portfolios. Our long-standing view that Brexit uncertainty would lead to the outperformance of Gilts versus other developed bond markets is no longer valid. It is still too soon to move to a full underweight stance on Gilts – a better opportunity will develop by mid-year once it is more evident that the current success on UK vaccinations leads to a faster reopening of the UK economy. Yield Curve: Maintain positioning for a bearish steepening of the UK Gilt yield curve. While there is limited scope for more steepening through an even larger increase in inflation breakevens from current elevated levels, the long end of the Gilt curve can move higher by more than the front end as the market re-rates Gilts to a higher-beta status with a higher future trajectory for UK interest rates. Corporate Credit: Downgrade UK investment grade corporate bond exposure to neutral from overweight in dedicated fixed income portfolios. UK corporate spreads have returned to the 2017 lows and, while an improving growth dynamic is not overly bearish for credit, there is no longer a compelling valuation-based case for staying overweight UK investment grade corporates. This move brings our recommended UK allocation in line with our neutral stance on US and euro area investment grade corporates. Chart 18GBP/USD Appears Cheap On A PPP Basis GBP/USD Appears Cheap On A PPP Basis GBP/USD Appears Cheap On A PPP Basis Chart 19Low Productivity Is Weighing On The Pound Low Productivity Is Weighing On The Pound Low Productivity Is Weighing On The Pound Currency: A growth-driven path towards interest rate normalization should be positive for the British pound, which remains undervalued versus the US dollar on a purchasing power parity basis (Chart 18).2 A move to 1.45 on GBP/USD is possible within the next six months. A broader move towards pound strength will require an improvement in business investment, as the trade-weighted pound looks fairly valued on our productivity-based model (Chart 19). We do maintain our view that EUR/GBP can approach 0.80 by year-end based on a relatively stronger cyclical improvement in UK growth versus the euro area.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For further details on the OBR estimates of UK growth, inflation and fiscal policy, please see the March 2021 OBR Economic & Financial Outlook, which can be found here: https://obr.uk/ 2 Please see BCA Research Foreign Exchange Strategy Report, "Thoughts On The British Pound", dated December 18, 2020, available at fes.bcaresearch.com.

Highlights China’s primary vulnerabilities over the past decade have been, and remain, credit/money excesses and a misallocation of capital. China’s advantage has not been its banking system or monetary policy’s "magic touch," but its ability to continuously raise productivity at a solid rate. Inflation has remained subdued due to robust productivity gains. Without the latter, policymakers would have little room to navigate and secure economic and financial stability. As long as solid productivity gains persist, the economy will absorb excesses over time and remain structurally sound. Feature China’s credit and fiscal stimulus has peaked and will roll over significantly in 2021. Hence, the question now is: what will be the extent of the economic slowdown? The magnitude of the growth slowdown depends not only on the pace and extent of credit and fiscal tightening but also on the structural health of the economy. In a structurally sound economy, the end of a credit and fiscal stimulus does not produce a sharp and extended slowdown. Conversely, in an economy saddled with structural malaises, modest policy tightening could produce a dramatic or prolonged business cycle downtrend. Two examples from China’s not-so-distant past are the credit tightening in 2004 and policy tightening in 2013-14. After the acute credit tightening in 2004 and the ensuing loan slowdown, China’s growth moderated briefly but remained robust and, in fact, reaccelerated in 2005 (Chart 1, top panel). However, following the 2013-14 policy tightening episode, China’s industrial sector experienced an extended downtrend (Chart 2, top panel). Chart 1China In Mid-2000s: Market Performance Amid Credit Tightening China In Mid-2000s: Market Performance Amid Credit Tightening China In Mid-2000s: Market Performance Amid Credit Tightening Chart 2China In Mid-2010s: Market Performance Amid Policy Tightening China In Mid-2010s: Market Performance Amid Policy Tightening China In Mid-2010s: Market Performance Amid Policy Tightening   Consistently, China-related plays in financial markets experienced only a brief and short-lived shakeout in 2004 and resumed their bull market within a short time span (Chart 1, bottom panel). But in 2013-15, China-plays experienced a deep and extended bear market (Chart 2, bottom panel). In this report, we assess the structural health of the mainland economy. “Soft-Budget” Constraints And Capital Misallocation China’s primary vulnerabilities over the past decade have been, and remain, credit excesses and a misallocation of capital. Loose credit and fiscal policies – “soft-budget” constraints – starting in 2009 fueled money creation on a grand scale, causing corporate and household debt to mushroom. This has massively inflated property prices and led to capital misallocation. Many of these excesses have by and large lingered. In particular: Broad money supply in China has surged 4.7-fold since January 2009 (Chart 3, top panel). This is significantly above the 2.3-fold increase in the US, and the 1.6-fold rise in the euro area and in Japan. Chart 3Broad Money Excesses: China Has Been An Outlier Broad Money Excesses: China Has Been An Outlier Broad Money Excesses: China Has Been An Outlier Not only has broad money supply skyrocketed in China by much more than in other economies, but it has also risen by much more relative to its own nominal GDP (Chart 3, middle panel). Since January 2009, as unorthodox monetary policies gained traction around the world, the broad money-to-GDP ratio has risen by 80 percentage points in China, 35-percentage points in the US, 25-percentage points in the euro area and 70-percentage points in Japan.     Chart 4China: No Deleveraging So Far China: No Deleveraging So Far China: No Deleveraging So Far Notably, China’s broad money-to-GDP ratio is the highest in the world, as illustrated in the middle panel of Chart 3. Finally, the absolute amount of broad money – all types of local currency deposits and cash in circulation converted into dollars to make numbers comparable – now stands at $40 trillion in China, $18 trillion in the US and the euro area each and $11 trillion in Japan (Chart 3, bottom panel). In brief, China’s money (RMB) supply is greater than the sum of money supply in the US and euro area. China’s domestic credit growth has been outpacing nominal GDP growth since 2008 (Chart 4, top panel). Consequently, its domestic credit-to-GDP ratio is making new highs (Chart 4, bottom panel). A continuously rising domestic debt-to-GDP ratio indicates that the nation has not really deleveraged in the past ten years. Concerning debt structure, local and central government debt stands at 61% of GDP, enterprise (including SOE) debt represents 162% of GDP and household debt is 61% of GDP. Notably, enterprise debt is the highest in the world, as illustrated in Chart 5.  This chart shows a decline in China’s corporate credit-to-GDP ratio from 2016 to 2018. The drop, however, is due to the Local Government Financing Vehicles (LGFV) debt swap. Authorities simply moved debt from LGFV balance sheets to local governments, which represents an accounting reshuffle and not genuine deleveraging. Meanwhile, households in China are as leveraged as those in the US (Chart 6) when debt-to-disposable income ratios are compared. The latter is how consumer debt is measured in all countries around the world. Chart 5Chinas Corporate Debt Is The Highest In the World Chinas Corporate Debt Is The Highest In the World Chinas Corporate Debt Is The Highest In the World Chart 6Chinese Households Are As Leveraged As US Ones Chinese Households Are As Leveraged As US Ones Chinese Households Are As Leveraged As US Ones Chart 7Debt Servicing Costs In China Are High Debt Servicing Costs In China Are High Debt Servicing Costs In China Are High Finally, the true indicator of debt stress is the debt-service ratio. The Bank for International Settlements (BIS) estimates that the debt-service ratio for Chinese enterprises and households is above 20% of income. The same ratio for the US rolled over at 18% in 2007 during the credit crisis (Chart 7). There are several symptoms consistent with pervasive capital misallocation. First, return on assets (RoA) for non-financial onshore listed companies has dropped to an 20-year low (Chart 8, top panel). Companies have raised substantial capital to invest but the return on investment has been disappointing, resulting in a falling RoA. Second, a falling output-to-capital ratio – an inverse analog of a rising incremental capital-to-output ratio (ICOR) – also indicates capital misallocation and falling efficiency (Chart 9). Chart 8Falling Return On Assets And Slowing Productivity Growth Falling Return On Assets And Slowing Productivity Growth Falling Return On Assets And Slowing Productivity Growth Chart 9Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling   Falling return on capital is the natural outcome of too much investment. It is simply impossible to invest more than 40% of GDP every year over a 20-year period without capital misallocation. It has become difficult to find profitable projects, especially as China’s economy is no longer as underinvested as it was 20 years ago. Falling efficiency ultimately entails lower productivity and, eventually, declining potential real GDP growth. Has China Deleveraged? Following such an epic credit boom, one would typically expect creditors in general and banks in particular to undertake profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold - RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, banks have not yet sufficiently cleansed their balance sheets. Not surprisingly, their share prices have been among the worst performers in the Chinese equity universe and in the EM space more generally. Overall, the Chinese economy was very healthy and was on an extremely solid foundation until the credit boom (“soft-budget” constraints) began in 2009. Since then, the economic model has bred inefficiencies which could weigh on growth going forward. One widely circulated counterargument against the thesis of excessive credit/money growth in China has been that Chinese households save a lot. As the argument goes, this is what has prompted banks to lend out those deposits. This analysis is incorrect, and we have written extensively about this topic in a series of reports that are available upon request. The interaction between money creation, credit and savings is outside the scope of this report. We therefore limit the discussion to the key inferences from the series of reports we published: National savings, including household savings, do not create money supply or deposits. Also, banks do not lend out deposits. Money/deposits are created by commercial banks when they make loans to, or buy assets from, non-banks. This is true for any economy in the world. Chart 10Gradual Deleveraging But No Crisis In Japan In 1990s Gradual Deleveraging But No Crisis In Japan In 1990s Gradual Deleveraging But No Crisis In Japan In 1990s We agree that Chinese households do have a high savings rate. However, their savings do not impact whether banks originate loans and create deposits, i.e., expand money supply. To expand their balance sheets, banks require liquidity/excess reserves, not deposits. In short, the enormous money supply in China has been an outcome of reckless behavior on the part of banks and borrowers rather than originating out of household or national savings. As such, at the current levels, Chinese money and credit represent major excesses and, thereby, pose risks to financial stability and long-term development. A pertinent question is as follows: Is there an economy that did not experience a credit crisis following a credit bubble? Japan is one example. Yet, Japan suffered from deleveraging. The top panel of Chart 10 demonstrates that bank loan growth peaked at 12% in 1990 and gradually slowed thereafter, ultimately contracting. The bottom panel of Chart 10 shows that Japan’s companies and households underwent gradual deleveraging beginning in the mid-1990s. Such a long lasting but gradual adjustment contrasts with the acute and sharp crisis that occurred in the US in 2007-08. To sum up, credit excesses do not need to culminate in a credit crisis; Japan being the primary example. However, it is unusual for the non-public debt-to-GDP ratio to continuously rise from already elevated levels. In brief, China has seen its money and credit excesses rise continually and the problem has yet to be addressed. Other Structural Headwinds Chart 11China Is Much More Industrialized Than Commonly Believed China Is Much More Industrialized Than Commonly Believed China Is Much More Industrialized Than Commonly Believed The Chinese economy is facing other structural headwinds: First, the oft-quoted 60% urbanization rate understates the extent of China’s industrialization. China is much more industrialized than generally perceived: the country’s industrialization rate is currently 85% – i.e., 85% of jobs in China are already in non-agricultural sectors (Chart 11). This entails a slower rate of industrialization and urbanization going forward. Second, the labor force is shrinking. This is a major drag on the nation’s potential real GDP growth rate – which is equal to the sum of productivity growth and labor force growth. In turn, productivity growth is estimated to have slowed down to about 6% with total factor productivity growth slipping to 2% (Chart 8, bottom panel, above). Chart 12Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending As we discussed in our recent Special Report A Primer On Productivity, productivity is the most important variable for any country’s long-term development and 6% is still a very high number. The challenge for China in the coming years is to prevent its productivity growth rate from dropping below 4.5-5%. Third, there is a misconception about what rebalancing really means for this economy. Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10.3% in real terms from 1998 until 2020 (pandemic) (Chart 12, top panel). Hence, the imbalance in China has not been sluggish consumer spending, which has actually been booming for the past 20 years. Rather, capital expenditure has been too strong for too long (Chart 12, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending decelerates? Our hunch is that this is unlikely. The basis is that investment outlays account for more than 40% of GDP and create many jobs and income, which in turn feeds into consumer spending. A meaningful downshift in capital expenditures will produce lower household income growth, resulting in a moderation in consumer spending growth. Bottom Line: Maturing industrialization, a shrinking labor force and an imperative to slow capital spending all constitute formidable headwinds to China’s secular growth outlook. China’s Advantage: What Makes It Distinct  Chart 13China Does Not Have An Inflation Problem China Does Not Have An Inflation Problem China Does Not Have An Inflation Problem Although all of the above structural drawbacks have persisted for the past ten years, the Chinese economy (1) has not experienced a credit crisis; and (2) has not seen an inflation outbreak despite burgeoning money supply. The question is: why? Concerning the credit excesses and the property bubble, China has avoided a credit crisis because its banking system has shown extreme forbearance towards debtors, i.e., banks have not forced corporate restructuring when companies were unable to service their debt. Besides, authorities – being fully aware of the risk of financial instability – have been lenient towards banks and debtors, tolerating continued credit overflow and rising credit excesses. The domestic credit growth rate has never dropped below nominal GDP growth (Chart 4 above). Rather, it has remained above 10% – despite several episodes of policy tightening and deleveraging campaigns. Authorities in any country with effective control over banks could do this. However, many economies with such a rampant money/credit boom would exhibit very high inflation. Yet, inflation in China has been absent (Chart 13). Critically, China’s advantage over other nations has not been its banking system or its monetary policy’s "magic touch" but its ability to continuously grow productivity at a solid rate. Inflation has remained subdued due to robust productivity gains. Without the latter, policymakers would have little room to navigate and secure economic and financial stability. The lack of inflation in China amid the credit and money boom is critical to understanding the unique structure and character of its economy. We have the following considerations: First, rampant money growth is typically associated with higher inflation because of the presumption that new money creation stimulates the demand for, but not the supply of goods and services. This is presently the case in the US where monetarization of public debt and fiscal transfers to households are boosting demand but not the potential productive capacity. However, in China’s case, credit flow to enterprises has always dwarfed credit to consumers. This means that the lion’s share of credit origination/money creation has been going directly into capital spending. Investment expenditures have led to rapid expansion of production capacity in the majority of industries. As a result, output has exceeded demand, resulting in an oversupply of goods and services and ultimately, in falling prices. Chart 14A and 14B illustrate that production capacity in many sectors in China has exploded over the past 20 years. In many industries, production capacity and output have expanded more than 10-fold since 2000. The outcome has been chronic deflation in many goods (Chart 15). Chart 14AProduction Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Chart 14BProduction Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries   In short, too much credit/money channeled into expanding production capacity could lead to deflation. Second, when banks make new loans/create new money, inflation occurs in goods/commodities that money is used to purchase. Those goods/commodities experienced periods of high price inflation during money/credit growth acceleration. For example, China’s credit/money growth impulse explains swings in commodities prices (Chart 16). Hence, the link between credit/money and certain goods/commodities prices has held up. Chart 15Goods Deflation Is Pervasive In China Goods Deflation Is Pervasive In China Goods Deflation Is Pervasive In China Chart 16Money Impulse Is Sending A Warning For Industrial Metals Money Impulse Is Sending A Warning For Industrial Metals Money Impulse Is Sending A Warning For Industrial Metals   Finally, the application of digital technologies in service sectors has kept a lid on service price inflation. Hence, China has benefited from productivity-enabled disinflation despite the ongoing money/credit boom. That said, there are also areas where there has been rampant inflation. These include land, housing and high-end services. On the whole, deflation in goods prices due to oversupply has overwhelmed the pockets of high inflation in services. Crucially, unit labor costs in both the industrial economy (secondary industry) and service sectors have been contained as strong wage growth has been offset by robust productivity gains (Chart 17). The following factors have enabled high productivity growth in China: Chinese people are genuinely entrepreneurial, hardworking and disciplined. Educational attainment has been rising and innovation has proliferated. China has closed the gap in all patents with the US (Chart 18, top panel). It has actually surpassed the US in the number of semiconductor patents (Chart 18, bottom panel). Chart 17Rising Wages But Stable Unit Labor Costs Rising Wages But Stable Unit Labor Costs Rising Wages But Stable Unit Labor Costs Chart 18China Has Become A Global Innovation Hub China Has Become A Global Innovation Hub China Has Become A Global Innovation Hub Chart 19China Is Pursuing Automation On A Large Scale China Is Pursuing Automation On A Large Scale China Is Pursuing Automation On A Large Scale Our report from June 24, 2020 has elucidated the nation’s innovation drive. Rising spending on research and development will ensure China’s continued ascent as a major global innovation hub. Consistent with rising productivity, China’s share in global trade continues to rise. China is aggressively implementing automation in many of its industries, replacing labor with robotics. Specifically, the number employees in the industrial sector has been falling while production of industrial robots - and presumably, demand for them - has surged (Chart 19). The outcome will be continued rapid productivity gains which will allow companies to keep a lid on costs and secure reasonable profit margins without resorting to price hikes. What could cause productivity growth to slow? The main risk is complacency associated with easy credit and recurring fiscal stimulus, i.e., “soft-budget constraints”. If zombie companies continue to enjoy easy access to financing and are not forced to restructure and become more efficient, the pace of productivity gains will decelerate with negative consequences for potential GDP growth and inflation. In such a case, the credit system’s forbearance towards enterprises that misallocate capital will continue channeling money to projects with low efficiency. The latter will increase the supply of goods and services that are not demanded. This will produce pockets of short-term deflation but will lay the foundation for higher inflation down the road.1  Bottom Line: China’s unique advantage has been its ability to avoid inflation despite the money/credit boom. Using a large share of credit to expand production capacity – rather than consumption – has been the key to maintaining low inflation. The latter has allowed policymakers to avoid material tightening policy and has kept the currency competitive.  In brief, the nation has been able to maintain reasonably high productivity gains, albeit slower relative to pre-2010. As long as productivity grows at a solid rate, the economy will over time absorb excesses with moderate pain/setbacks and will do well structurally. Investment Considerations Appreciating the long-term negative ramifications of “soft-budget” constraints, Chinese policymakers have embarked on another tightening campaign since last summer. This policy stance will continue, and the economy is now facing triple tightening: Monetary and fiscal tightening: The total social financing and our broad money (M3) impulses have already rolled over (Chart 16 above). Fiscal policy will also tighten relative to the unprecedented stimulus of last year. Regulatory tightening on banks and non-bank financial institutions: Authorities are planning to reinforce asset management regulation by the end of this year. This will limit how much these financial institutions can expand their balance sheets reinforcing a credit slowdown. Property market tightening: Restrictions on both property purchases and property developers’ leverage will lead to a notable slump in real estate construction. Chart 20Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks As China’s credit-sensitive sectors – construction and infrastructure spending – slow down this year, the risk-reward for industrial commodities and other China-plays worldwide is poor. Regarding Chinese stocks, Chinese A-shares will begin outperforming Chinese Investable stocks (Chart 20). We recommend the following strategy: long A shares / short China investable stocks. The primary reason is that the A-share index is heavy in value stocks while the MSCI China investable index has a large weight in expensive new economy stocks. The global investment backdrop has shifted in favor of global value versus global growth stocks due to strong US growth and rising US bond yields. Also, there has been more rampant speculation in global stocks that affect Chinese investable stocks more than onshore equities. Notably, the Composite A-share large and A-share small cap indexes have not performed well since July while investable stocks had been surging until recently. As to the exchange rate, the RMB is overbought and will likely experience a setback as the US dollar rebounds. However, the yuan’s long-term outlook versus the US dollar depends on the relative productivity growth. As long as the productivity growth differential between China and the US does not narrow, the RMB will appreciate versus the dollar on a structural basis. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Deflation can turn into inflation when the economy produces goods/services that are not demanded (type A goods) and not producing the ones that are in demand (type B goods). As a result, prices of type A goods will deflate often overwhelming inflation type B goods keeping overall inflation very low. Consequently, production of type-A goods will halt because plunging prices will discourage output. As a result, deflation will abate in the economy. If the economy still cannot produce type-B goods – the ones in demand, inflation will become prevalent.

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

Highlights GameStop & Bond Yields: The reflationary conditions that helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Remain overweight the latter versus the former. Italy: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year. Feature Dear Client, The next Global Fixed Income Strategy publication will be a Special Report on Canada, jointly published with our colleagues at Foreign Exchange Strategy on Friday, February 12. We will return to our regular publishing schedule on Tuesday, February 16. Rob Robis, Chief Global Fixed Income Strategist Chart of the WeekExpect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness The “Reddit Retail Revolution” has exposed the dangers of staying too long in crowded short positions for equities like GameStop, but bond markets were unfazed by the wild moves in stocks last week. US Treasury yields actually crept upwards as the mother of all short squeezes became the top news story in America. Corporate credit spreads worldwide were essentially unchanged, despite the pickup in US equity volatility measures like the VIX. Bond investors recognize that, while the sideshow of rebel traders taking on mighty hedge funds makes for great theater, the underlying reflationary global policy backdrop remains the main driver of global bond yields and credit risk premia (Chart of the Week). Global fiscal policy risks are increasingly tilted towards more stimulus than currently projected, even as the pace of new COVID-19 cases is starting to slow in the US and much of Europe. Vaccine rollouts in many countries are going far slower than expected, which has forced global central banks to commit to maintaining highly accommodative policies - zero interest rates, quantitative easing (QE) and cheap bank funding – for longer. As Fed Chair Jerome Powell noted in his press conference following last week’s FOMC meeting, “There’s nothing more important to the economy now than people getting vaccinated.” Chart 2Vaccine Rollout Critical For Fed/ECB/BoE Policy The Revolution Will Be Monetized The Revolution Will Be Monetized On that front, the largest economies on both sides of the Atlantic continue to perform poorly. According to data from the Duke Global Health Innovation Center, vaccination coverage (defined as actual vaccination doses acquired on a per person basis) in the US, UK and European Union remains low relative to the intensity of COVID-19 cases within the population (Chart 2) – especially compared to the experience of other major Western countries.1 As we discussed in last week’s report, it is far too soon for investors to fear a hawkish move by global central banks towards tapering asset purchases and signaling future interest rate hikes.2 The GameStop episode may cause some policymakers to worry about the financial stability risks resulting from cheap money policies, but not before the greater risks to global growth from the COVID-19 pandemic are contained. Until vaccination rates rise to levels where there is the potential for herd immunity to be reached, central banks will have little choice by to maintain 0% (or lower) policy rates for longer with continued expansion of their balance sheets (Chart 3). Policy makers will even likely respond with more QE in the event of broad financial market turmoil occurring before inflation expectations return to central bank targets (Chart 4). Chart 3Expect More Global QE ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 4...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields We continue to recommend the following medium-term positioning for reflation-based themes in global fixed income markets: below-benchmark overall duration exposure, favoring lower-quality corporate bonds versus government debt, and underweighting US Treasuries within global government bond portfolios. Bottom Line: The reflationary conditions that have helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Italy: ECB Policy Trumps Political Uncertainty One of our highest conviction fixed income investment recommendations over the past year has been to overweight Italian government bonds (BTPs). We have maintained that bullish stance with an expectation that Italian bond yields (and spreads over German debt) would converge to the levels of Spain, restoring a relationship last seen sustainably in 2016 (Chart 5). Chart 5A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty The recent collapse of the coalition government of Prime Minister Giuseppe Conte would, in a more “normal” time, represent a serious threat to the stability of the Italian bond market and our bullish view. Yet the response so far has been muted, with the spread between 10-year BTPs and German Bunds up only 11bps from the mid-January lows. The current political drama stemmed from a disagreement within the ruling coalition over how the government was planning to use Italy’s share of the €750bn EU Recovery Fund. As we go to press, the survival of the current government hangs in the balance, with President Sergio Mattarella testing whether the political parties can form a government with a majority. The initial announcement of that Recovery Fund was considered to be a major reason for a reduced risk premium on Italian government bonds, as it represented a potential step towards greater fiscal integration within Europe. Unfortunately, it took the COVID-19 crisis to get the rest of Europe to offer help to the more economically fragile countries like Italy. The country suffered one of the world’s worst initial waves of the virus and the late-2020 surge has also hit hard – although, more recently, Italy has fared far better than Southern European neighbors Spain and Portugal with a slower pace of new cases and hospitalizations (Chart 6). Italy’s economy has struggled under the weight of some of the most stringent restrictions on activity within Europe to stop the spread of the virus, according to the Oxford COVID-19 database (Chart 7). Domestic spending on retail and recreation activities is estimated to be down nearly 50% from the start of the pandemic, a hit to the economy made worse by the collapse of tourism revenue that will take years to fully recover. In other words, Italy desperately needs the money from the EU Recovery Fund. Chart 6Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Chart 7A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 Former Prime Minister Matteo Renzi and his Italia Viva party precipitated the crisis by withdrawing their support from Conte’s coalition, but are in a weak position electorally. They claim that the funds should be handled by parliament, rather than a technocratic council overseen by Conte, and devoted to long-term structural reform rather than short-term fixes. Renzi’s withdrawal from the ruling coalition, however, is not grounded in substantial disagreements over fiscal spending: First, the EU recovery fund requires all member states to use 30% of the funds on climate change initiatives and 25% on digitizing the economy, and none of the major parties oppose this use of the €209 billion coming their way. Second, Prime Minister Conte adjusted his spending plans, nearly doubling the allocations for health, education, and culture, in response to Renzi’s criticisms that not enough spending focused on structural needs. Third, Renzi wants to tap €36 billion from the European Stability Mechanism in addition to taking recovery funds, but this would come with austerity measures attached (which is self-defeating) and would be opposed by the left-wing populist Five Star Movement, a linchpin in the ruling coalition. Even if the immediate political turmoil passes, there will still be an elevated risk of an early election as the various parties jockey for power in the wake of the cataclysmic pandemic, and as they eye control of the presidency, which is up for grabs in 2022. The only real change on the fiscal front would come if the populist League and Brothers of Italy ended up winning a majority and control of government in the eventual elections, as they favor much greater fiscal largesse. It is possible that Conte will survive as his personal support has increased throughout the crisis. Otherwise, former ECB President Mario Draghi could replace him, although he is now less popular than Conte. President Mattarella is not eager to dissolve parliament given that the combined strength of right-wing anti-establishment parties is greater than that of the centrist and left-wing parties in the ruling coalition judging by public opinion polls (Chart 8). Yet sooner rather than later, a new election looms. The country already completed an electoral reform via a referendum in September 2020 that cleared the way for a new election to be held. Chart 8Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Chart 9Waning Immigration Undercuts Italian Populists (For Now) The Revolution Will Be Monetized The Revolution Will Be Monetized The current crisis is different than past bouts of Italian political uncertainty as there is less of a question over Italy’s commitment to the euro - which in the past has resulted in higher Italian bond yields and wider BTP-Bund spreads as markets had to price in euro breakup risk. The current coalition, and any new coalition cobbled out of the current morass to prevent a snap election, are united in their opposition to the populist League and the Brothers of Italy. They will strive to remain in power to distribute the EU recovery funds and secure the Italian presidency for an establishment political elite – one, like Mattarella, who will act as a check on the power of any future populist government and its cabinet choices, just as Mattarella himself hobbled the League’s most radical proposals from 2018-19. Chart 10Italian Support For EU & The Euro Sufficient But Not Ironclad The Revolution Will Be Monetized The Revolution Will Be Monetized While the right-wing “sovereigntist” parties lead in the opinion polls, the League has lost support since its leader Matteo Salvini’s failed bid to trigger an election in August 2019 and especially since the COVID-19 outbreak has boosted the establishment parties and coalition members. Anti-immigration sentiment, a key support of this faction, has subsided as the EU has cut down the influx of immigrants (Chart 9). Salvini and his supporters have also compromised their euroskepticism to appeal to a broader audience as 60% of the populace still approves of the euro – although this support is falling again and bears monitoring (Chart 10). Another economic shock or a new wave of immigration could put the right-wing populists into power. Moreover, an unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. Thus, the risk of euroskepticism and fiscal populism will persist over the coming two years, even though they are most likely contained at the moment. Has The ECB Removed The Tail Risk Of BTPs? The ECB has shown they are willing to use their balance sheet via QE and cheap bank funding tools like TLTROs to support the euro area’s weakest link – Italy. Thus, any upward pressure on Italian bond yields/spreads from the current political fracas will almost certainly be met by a more aggressive ECB response (more QE for longer, new TLTROs), limiting the damage to the Italian bond market. Chart 11What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? The ECB’s TLTROs appear to have been helpful for Italy, whose LTRO allotments represent 14.7% of total bank lending (Chart 11). Yet Spanish banks have relied on cheap ECB funding to a similar degree, while the growth of bank lending in Italy has substantially lagged that of Spain since the start of the pandemic in 2020 – even with Italy having less restrictive lending standards according to the ECB’s Bank Lending Survey. The ECB has also helped Italy by being more flexible with its purchases of Italian government bonds within both the Public Sector Purchase Program (PSPP) and the Pandemic Emergency Purchase Program (PEPP) that began in response to COVID-19. ECB data show that, after the worst days of the COVID-19 market rout last spring when the 10-year Italian bond yield soared from 1% to 2.4% over just three weeks, the ECB increased the Italy share of its bond buying to levels well above the Capital Key weighting scheme that “officially” governs the bond purchases. This was true within both the PSPP (Chart 12) and the PSPP (Chart 13). Chart 12ECB Paying Less Attention To The Capital Key In The PSPP ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 13… And The PEPP The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 14Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds The ECB’s actions helped stabilize Italian bond yields, sowing the seeds of the major decline in yields that took place between April and September. Once Italian bond yields fell back to pre-pandemic levels, the ECB slowed the pace of its purchases of Italian bonds to levels at or below the Capital Key weights. Thus, the ECB was willing to deviate from its own self-imposed rules for its bond purchase schemes in order to ease financial conditions in Italy during a pandemic. There is no reason to believe that would not occur again if yields rise because of a growing political risk premium while the pandemic was still raging. A prolonged period of political uncertainty in Italy, especially one that ends with fresh elections, could even force the ECB to maintain or extend its full current mix of policies and not just QE. For example, a new TLTRO could be initiated later this year, or the subsidized cost of banks borrowing from existing TLTROs could be reduced further, all in an effort to help boost Italian lending activity. More likely, the PEPP could be expanded in size or extended beyond the current March 2022 expiration, or the PSPP could be upsized to allow for more purchases of Italian debt (Chart 14). From an investment strategy perspective, there is still a strong case for overweighting Italian government bonds in global fixed income portfolios, even with the current political uncertainty. The weight of ECB policy actions removes much of the usual upside risk to BTP yields. However, investors will likely be more reluctant to drive Italian yields (and spreads versus Germany) to fresh lows if there is a risk of early elections, as we expect. Italian bonds are now more of a pure carry with yields trapped between politics and QE, but that still justifies an overweight stance - especially given the puny levels of alternative sovereign bond yields available elsewhere in the euro area. Bottom Line: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The Duke Global Health Innovation Center data on COVID-19 can be found here: https://launchandscalefaster.org/COVID-19. 2 Please see BCA Research Global Fixed Income Strategy Report, "A Pause, Not A Peak, In Global Bond Yields", dated January 26, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Revolution Will Be Monetized The Revolution Will Be Monetized Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem China's Unemployment Problem China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending China Will Surge R&D Spending China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 China's Growth Target Through 2025 China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Chart 13China Pares Local Government Spending Too China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Renminbi Fairly Valued Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought China: Investable Stocks Overbought China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Go Long Chinese Government Bonds Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.