Equities

Highlights Earnings season was impressive, with 87% of companies beating analyst earnings expectations. Analysts’ targets were too low because a whopping 38% of companies provided negative forward guidance for the Q2-2021 results. The markets expect 12-17% earnings growth over the next 12 months. Growth is past its peak and is returning to trend. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet, returns will be lower than in the past due to high valuation “speed limit.” US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent up demand for elective procedures will propel earnings growth higher. Overweight Industrials to benefit from the US manufacturing Renaissance long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Feature The Q2-2021 earnings season is coming to an end, and it is time to take stock of the companies’ results and validate our equity views on styles, sectors, and investment themes into the balance of the year. Review Of The Q2-2021 Earnings Season The S&P 500 Key Earnings Results Stats S&P 500 quarterly earnings grew 93% YoY, and sales increased by 23.5% YoY compared to the same quarter a year ago (Table 1). Q2-2021 earnings stand 29% above the Q2-2019 level, which translates into 14% annualized growth. CAGR for sales for the same period is 4.6%. 87% of the companies have beaten both sales and earnings expectations. Earnings surprise is 16%, while sales surprise is 4.6%. As our colleagues from US Investment Strategy (USIS) have observed, beats are unprecedented: Their magnitude is more than two standard deviations above the historical average (Chart 1). Table 1S&P 500 Q2-2021 Earnings And Sales Results Chart 1Earnings Surprises Are Unprecedented Decoding The S&P 500 Earnings Season Results While we are impressed with the earnings results delivered by the US companies, our reaction to these superb growth numbers and beats is tepid, like the market’s reaction. The average reaction to an EPS beat this earnings season was about 0.9%. Misses were penalized harshly with stocks falling 1.1%. S&P 500 is up only 2% since the beginning of the reporting season. There are a few reasons for this lukewarm reception: Analyst targets were too low: Ubiquitous beats of earnings and sales expectations indicate that the analyst targets were too low despite upgrades throughout the earnings season (downgrades are more typical). The bar was set too low because a whopping 38% of the companies provided negative forward guidance for the Q2-2021 results. Growth was lumpy: Much of the robust growth can be explained by what we can call two sides of the same coin, one being a low base for the comparisons – after all, in the summer of 2020, the economy was close to a standstill – and the other is a pent-up demand for goods and services. In other words, all the growth postponed in 2020 was delivered at once over this past couple of quarters. With that, a 14% annualized growth rate for the S&P 500 earnings since 2019, which smooths results over time, is strong but not exceptional. Corporate guidance was cautious: Many companies have warned investors that their high growth rates are unsustainable (31% of companies guided lower for Q3-2021). Since the markets are forward-looking, reported earnings growth is seen in the rearview mirror and is priced in, and it is future growth that matters. Earnings growth has returned to trend: Earnings have fully recovered from the pandemic dip. The street bottom-up EPS growth projections (according to Refinitiv) for the rest of 2021, 2022, and 2023 are based on that assumption (Chart 2). The corollary to the point above is that earnings growth has peaked (Chart 3, RHS): Earnings will grow forward along the trend line at about 6-8% annually, which is the historical average. Chart 2Earnings Growth Is Returning To Trend What To Expect Over The Next Four Quarters? According to the data compiled by Refinitiv, analysts expect Q3-2021 earnings to be 5% (QoQ) below their Q2-2021 level, staying flat for the next couple of quarters and exceeding the current level only in Q2-2022 (Chart 3, LHS). Aggregating quarterly growth rates into next 12 months growth rate, analysts expect 12.6% YoY growth over the next 12 months. Chart 3Growth Has Peaked And Quarterly Earnings Are Expected To Be Almost Flat We believe that these growth expectations are too low, as they are based on the expectation that over the next four quarters EPS will stay practically flat. Therefore, most of the 12.6% YoY growth can be attributed to a base effect. It is likely that YoY growth will be higher: Some sector earnings are still at a pre-pandemic level, while others should grow simply because the economy is expanding. IBES expects EPS NTM to grow at 17% over the next 12 months, which is slightly more realistic in our opinion (Chart 4). The difference with Refinitiv is in the calculation methodology. Our working assumption is that next year’s growth will be within the 12-17% YoY range. From Multiple Expansion To Earnings Growth! Return decomposition demonstrates that in 2020, the S&P 500 return was 26%, with 43% contributed by the multiple expansion, and 19% detracted by the earnings contraction: Over the past year, returns have been borrowed from the future, but this year is payback time. The source of the equity returns is shifting from multiple expansion to earnings growth. This means that 12%-17% expected EPS growth (and possibly more if we get a positive earnings surprise) in the upcoming four quarters will propel the markets higher (Chart 5). Chart 4IBES Expect Next 12 Months Growth To Be 17% Chart 5Earnings Growth Replaces Multiple Expansion As A Driver Of Returns Will the S&P 500 Grow Into Its Big Valuations Shoes? Not So Fast At present, the S&P 500 is trading at 21.3x forward earnings (PE NTM), which is steep compared to a historical average of 18x. PE NTM multiples will compress if earnings growth exceeds index price appreciation. While we do expect multiple expansion to pass the baton to earnings growth over the next 12 months, we are curious to know by how much earnings would have to grow for PE to come down to 18x. To get an answer, we created a scenario analysis matrix, varying price and earnings growth simultaneously. The most likely scenario is for the earnings to grow at 3-5% each quarter over the next 12 months (13-16% annualized) and, assuming that the S&P 500 price does not move, it will trade at 20.5-21x forward earnings multiples. For PE to come down to 18x, earnings would have to grow by more than 10% every quarter, or 30% over the next 12 months, which is way above the growth rates expected by the market. Therefore, we are unlikely to see significant multiple compression without a market correction (Table 2). US equities are expensive, no excuses. Table 2Earnings Have To Grow in Double-Digits For PE NTM To Come Down To 18x Zooming In On The US Equity Market Segments Table 3Style Indices Q2-21 Sales And Earnings GrowthValue Outgrew Growth: Earnings of Value grew 31% faster than earnings of Growth (Table 3). However, looking under the hood, annualized EPS growth of Growth was 16% p.a. since 2019, while EPS of Value contracted by 2% p.a. This means that for many Value companies, the earnings surge is a function of the base effect; earnings have not yet reached their pre-pandemic levels (Chart 6) and have room to run further. Chart 6Small Delivered Spectacular 2019-2021 Growth Small Crushes Earnings: Small Caps' quarterly results have been nothing short of astonishing: EPS in Q2-21 is 10 times higher than during the same quarter a year ago. This growth surge can’t be attributed just to the base effect, as earnings are double what they were two years ago. The S&P 600 has an annualized earnings growth rate over the past two years of 42%, and sales growth of 6.2%. Sectors Sector results are characterized by a powerful rebound of the cyclical sectors: Industrials, Consumer Discretionary, Energy, Materials, and Financials have delivered triple-digit earnings growth, and double-digit sales growth (Table 4). Table 4S&P 500 Sectors' Q2-21 Sales And Earnings Growth However, looking at 2019-2021 CAGR, we observe that the Industrials sector earnings are still 10% below the 2019 level, and the Consumer Discretionary sector has only grown 2% annualized, much slower than the market. The case is the same for Energy. Financials and Materials growth was very strong: The former benefited from the M&A and IPO boom, while the latter has grown thanks to stimulative Chinese policy, which has been tightened lately (Chart 7). Chart 7Cyclical Sectors Did Not Grow Much Since 2019 Despite Recent Profit Rebound Profitability Is Unlikely to Return To A Previous Peak Many companies have tightened their belts during the pandemic to preserve capital in the face of uncertainty. Margins have compressed, but less than expected in such a dire situation. Currently, the majority of sectors has margins close to their historical averages (Chart 8). While most sectors, with exception of Financials and Technology, are below peak margins, it is unlikely that they will be able to return to their former highs. Sales will soar thanks to stimulative fiscal and monetary policies, strong demand by consumers, and inflation. Yet the bottom line may be impeded by the increases in labor and input costs and tighter fiscal policy, which have not yet been priced in by the market. Market Expectations For The Next 12 Months According to IBES, earnings growth will be propelled by the cyclicals, such as Industrials, Consumer Discretionary and Energy (though less so as it is a small sector). These expectations are well aligned with our investment thesis (Chart 9). Chart 8Most Sectors' Margins Are Back To Normal, But Peak Margins Are Elusive Chart 9Cyclical Sectors Are Expected To Grow The Most Over The Next 12 Months Investment Themes Consumers Are Flush With Cash One of our key investment themes is that the US consumer still has plenty of money to spend: Excess savings in the US currently stand at $2.5 trillion, and disposable incomes have been padded by the pandemic helicopter cash drops. While spending on goods had exceeded its historical trend and has recently turned, spending on services is still below pre-pandemic levels (Chart 10). During Q2-2021, Consumer Services earnings grew by 154%, exceeding analyst targets by 27%, though the level of earnings is only 5% above the Q2-2019 level (Chart 11). This suggests that the theme has worked, but also that it has the potential to run further only if not derailed by the fear of COVID-19 variants. However, the approach to investing in this sector needs to be granular, with overweights allocated to service industries such as hotels, restaurants, and leisure (S&P leisure products, S&P hotels, S&P restaurants). Chart 10Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Chart 11The Consumer Discretionary Sector Growth Will Stay Robust We recommend staying away from Internet Retail (downgrade is pending) and the other sectors that have outsized exposure to consumer goods. Amazon earnings were a case in point: The company disappointed analysts with weaker revenue growth as well as provided a more cautious outlook as it finds it difficult to surpass its stellar pandemic numbers. Brick and mortar retail is likely to fare better, as going out to shop now falls into the “experiences” basket. China Slowdown: Underweight The Materials Sector Chinese growth is slowing, which has an adverse effect on demand for industrial metals (Chart 12). As a result, we have underweighted the Materials sector, along with the Metals and Mining industry. This call was on the money: While Materials more than doubled earnings over the past year, its earnings surprise at 6.40% is the smallest of all the sectors. The Materials sector has underperformed S&P 500 by 8% since the beginning of June. Chart 12Materials Sector Earnings Growth Is Slowing Post-COVID-19 Normalization: Overweight The Health Care Sector We upgraded this sector to an overweight three weeks ago. We intended to add a defensive sector in our portfolio to make it more robust in the face of an imminent market pullback, likely volatility on the back of elevated valuations and the upcoming debt ceiling kerfuffle. This quarter, Health Care posted mixed results despite being among the key beneficiaries of the pandemic. There are several factors at play. One is that some US vaccine manufacturers pledged to produce vaccines at no profit (J&J). Another reason is that the pandemic forced hospitals to halt their non-emergency operations that serve as an important end-demand market for the S&P Health Care sector. Weak Q2-2021 earnings suggest untapped demand for medical services and elective procedures. Just now, hospitals started reopening, and we expect a spike in the number of hospital visits, with positive spillover effects for medical equipment manufacturers and pharmaceutical companies. We are sticking to our overweight unless Delta and Lambda take over the hospital beds. US Manufacturing Renaissance The Industrials delivered triple-digit growth, but the sector’s earnings are still below pre-pandemic levels. There was an earnings growth dichotomy at play. Manufacturing companies that derive a high percentage of earnings from abroad have been affected by a slowdown of Chinese demand and by inflationary pressures. CAT’s recent 20% drawdown in relative terms encapsulates these headwinds. Domestic and services-oriented stocks like railroads reported exceptionally strong demand. Looking ahead, we are constructive on the sector. There is still significant pent-up demand for industrial goods and services, inventories are historically low (Chart 13) and need to be replenished, Federal infrastructure spending is a near certainty, and onshoring of US manufacturing is a new structural theme. Analysts concur: Expected EPS growth for the sector over the next 12 months is 46%. Chart 13Inventories Are At All Time Low Chart 14Value-Growth Earnings Growth Differential Is Closing Rate Stabilization: Overweight Technology and Growth vs Value Technology is one of our core overweights in the portfolio and the sector fared well last quarter. One of the drivers behind the strong quarter is an accelerating shift to remote work as companies re-evaluate the need for offices, especially given the possibility of new virus variants. A similar upbeat message came from the semiconductor industry: A shortage of chips that touches all corners of manufacturing from cars to computers, translates into strong earnings growth, which is likely to continue far into the future. As our BCA colleague, Arthur Budaghyan observed, semiconductor chip manufacturing is becoming a strategic asset, especially in a standoff between China and the US, and the country that controls the production of semis controls the production of most tech goods. We have been overweight Growth vs Value in our portfolios since the beginning of June. Since then, Growth has outperformed Value by about 6%. While Value was growing faster than Growth in Q2-21, the earnings growth expectation between Growth and Value is closing. After a strong run, Growth is expensive again, trading at 28x forward earnings compared to 16x for Value. We expect the yield curve to steepen and yields to rise this fall once workers return to work and the unemployment rate falls further. In other words, we are edging closer to downgrading Growth to neutral; we are just waiting to get more visibility on the Delta variant scare. Upgrade Small vs Large When Rates Rise Again Back in June, we wrote a deep-dive report on Small / Large cap allocation and concluded that an equal-weighted allocation was warranted. This call has not worked so far as Small has underperformed Large by about 5%. Our reasons for not overweighting Small vs Large were manifold: Slowing growth, flattening yield curve, mean reversion of high-yield spreads and, most importantly, a significant downgrade of earnings expectations (Chart 15). Chart 15Small Cap Downgrades Likely Ran Their Course However, we are warming up to Small: Reported earnings and sales growth was impressive. Furthermore, we expect the yield curve to steepen (helping banks in the S&P 600) as people go back to work in September, and rates to go up to as high as 1.8% by the end of the year. When the timing is right, we will swap overweight in the Growth stocks to an overweight in Small. Investment Implications The earnings season was impressive, but growth is returning to trend and is past its peak. The markets expect 12-17% earnings growth over the next 12 months. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet returns will be lower than in the past due to a high valuation “speed limit.” The US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent-up demand for elective procedures will propel earnings growth higher. Overweight Industrials which will benefit from the US manufacturing Renaissance over the long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending over the short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Bottom Line The earnings season produced peak growth, and the next phase of the cycle is earnings growth returning to trend. This normalization will be a tailwind for the equity markets and will replace multiple expansion as a driver of equity returns. We are sticking to our overweights in Industrials, Health Care and Consumer Discretionary, and our underweight in Materials. We are reconsidering our overweight in Growth and neutral positioning in Small Caps. Once rates turn up decisively, a rotation into Small and Value is warranted.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Chart 6US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.

Following up on yesterday’s Sector Insight report where we addressed the question of “how much inflation is too much” for the SPX multiple, today we conduct a similar analysis, but for earnings. Table 1 below illustrates that as long as inflation remains below 3%, earnings are not affected by the rising prices. However, crossing the 3% mark results in turbulence, especially once inflation accelerates beyond 4%. Specifically, column 6 of the table that corresponds to CPI rising above 4% displays mean and median YOY LTM earnings growth of negative 11% and negative 18%, respectively. One of the reasons why earnings suffer during high inflation is because companies have trouble passing on cost increases and are forced to sacrifice margins and earnings. These results are also consistent with the interplay between inflation and SPX multiple we showed yesterday. Bottom Line: While inflation is a concern, our view remains that as long as long-term inflation readings stay below 3%, equity earnings growth will shrug off price increases. Table 1Inflation Lagged 12 months vs LTM Earnings YoY

Special Report

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased Chart 5India’s Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond Chart 7India’s Importance As An Oil Client Has Been Rising The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share Chart 12India’s Appetite For Arms Imports Is Falling Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.

Weekly Performance Update For the week ending Thu Aug 12, 2021 The Market Monitor displays the trailing 1-quarter performance of strategies based around the BCA Score. For each region, we construct an equal-weighted, monthly rebalanced portfolio consisting of the top 3 stocks per sector and compare it with the regional benchmark. For each portfolio, we show the weekly performance of individual holdings in the Top Contributors/Detractors table. In addition, the Top Prospects table shows the holdings that currently have the highest BCA Score within the portfolio. For more details, click the region headers below to be redirected to the full historical backtest for the strategy. BCA US Portfolio Total Weekly Return BCA US Portfolio S&P500 TRI 1.92% 0.77% Top Contributors   ANAT:US TX:US COKE:US MPLX:US R:US Weekly Return 43 bps 32 bps 16 bps 13 bps 11 bps Top Detractors   MAA:US BMY:US EOG:US IQV:US EXR:US Weekly Return -8 bps -7 bps -4 bps -3 bps -2 bps Top Prospects   TX:US ESGR:US SC:US IT:US MPLX:US BCA Score 97.76% 97.12% 96.66% 93.62% 93.56% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI 1.45% 0.77% Top Contributors   WIR.UN:CA ATZ:CA WSP:CA LNF:CA WFG:CA Weekly Return 49 bps 30 bps 21 bps 13 bps 13 bps Top Detractors   CRON:CA DCBO:CA TOU:CA ONEX:CA EMP.A:CA Weekly Return -32 bps -10 bps -6 bps -5 bps -4 bps Top Prospects   RUS:CA PXT:CA TOU:CA CS:CA ELF:CA BCA Score 97.10% 96.65% 95.68% 95.64% 95.54% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI 1.71% 1.39% Top Contributors   MXCT:GB AAF:GB DEC:GB 888:GB SSE:GB Weekly Return 40 bps 21 bps 17 bps 16 bps 16 bps Top Detractors   DATA:GB NLMK:GB SVST:GB SRE:GB GROW:GB Weekly Return -14 bps -12 bps -10 bps -6 bps -4 bps Top Prospects   SVST:GB VVO:GB NLMK:GB TUNE:GB CTH:GB BCA Score 99.30% 98.26% 96.72% 95.21% 94.84% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI 1.54% 1.45% Top Contributors   HLAG:DE ARTO:FR TESB:BE ROTH:FR STR:AT Weekly Return 35 bps 22 bps 17 bps 13 bps 11 bps Top Detractors   ALESK:FR LOUP:FR NESTE:FI MBH3:DE EDNR:IT Weekly Return -27 bps -7 bps -3 bps -1 bps 0 bps Top Prospects   FDJ:FR STR:AT SOLV:BE IPS:FR EDNR:IT BCA Score 97.99% 97.67% 97.18% 96.81% 96.17% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI 1.04% 1.27% Top Contributors   4694:JP 1419:JP 9543:JP 7958:JP 3291:JP Weekly Return 37 bps 18 bps 14 bps 14 bps 11 bps Top Detractors   5021:JP 3468:JP 8977:JP 8097:JP 3132:JP Weekly Return -16 bps -12 bps -5 bps -4 bps -4 bps Top Prospects   6960:JP 9436:JP 4966:JP 2208:JP 5930:JP BCA Score 99.88% 99.82% 99.68% 99.61% 99.27% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI 0.34% 1.19% Top Contributors   1866:HK 316:HK 857:HK 1277:HK 98:HK Weekly Return 45 bps 19 bps 18 bps 15 bps 15 bps Top Detractors   6118:HK 990:HK 148:HK 691:HK 973:HK Weekly Return -49 bps -28 bps -14 bps -12 bps -10 bps Top Prospects   1277:HK 691:HK 215:HK 2877:HK 98:HK BCA Score 99.99% 98.52% 98.13% 96.98% 96.82% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI 1.29% 1.12% Top Contributors   YAL:AU NHC:AU JLG:AU CAJ:AU ARF:AU Weekly Return 66 bps 27 bps 25 bps 21 bps 18 bps Top Detractors   REA:AU PSQ:AU AQZ:AU EZL:AU AX1:AU Weekly Return -31 bps -24 bps -21 bps -19 bps -11 bps Top Prospects   MGX:AU GRR:AU MHJ:AU ARF:AU PIC:AU BCA Score 99.63% 99.45% 97.40% 96.12% 96.06%

Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story.   Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent.  Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The greatest legislative battle of the Biden presidency will unfold between now and the end of the year.   Biden’s bipartisan infrastructure deal is likely to pass the Senate soon but will have to cross several hurdles before passage in the House of Representatives. We maintain our 80% subjective odds that it will pass one way or another. Assuming the infrastructure bill does not fall apart, we will upgrade the odds that Biden’s budget reconciliation bill will pass this fall from 50% to 65%. The latter comprises a nominal $3.5 trillion in social spending and tax hikes that will be watered down and revised heavily by the time it passes, which may take until Christmas. Uncertainty about passage will cause volatility to rise in financial markets. Democrats left the debt ceiling out of their fiscal 2022 budget resolution, which ostensibly means they cannot raise the debt limit via a simple majority but will need 10 Republican senators to join. A bruising standoff will ensue that will add to volatility. Ultimately Republicans will comply as they cannot afford to be held responsible for a default on the national debt. The party is currently unpopular and tarred with accusations of insurrection. If Biden succeeds in passing both bills, US fiscal policy will be frozen in place through at least 2025, though endogenous disinflationary fears will largely be dispelled. Feature The biggest domestic political battle of the Joe Biden presidency is likely to occur between now and Christmas. With a one-seat de facto majority in the Senate, and a four-seat majority in the House, Biden is barely capable of passing his two outstanding legislative proposals. The first of these is the $550 billion bipartisan infrastructure deal, which we have given an 80% subjective chance of passing and which passed the Senate on a 69-30 vote margin as we went to press. The second is the $3.5 trillion partisan reconciliation package, based on the remainder of Biden’s American Jobs and Families Plan, which we have given a 50% chance of passage. We will upgrade these odds to 65% if bipartisan infrastructure does not fall through in the House. Next year will be consumed by campaigning for the 2022 midterms so it will be hard to pass any major legislation with such thin majorities (though bipartisan anti-trust legislation could pass and poses a risk to the equity market). The midterms are likely – though not guaranteed – to result in Republicans taking at least the House. The result will be gridlock in which only the rare bipartisan bill can pass. In other words, after Christmas, Biden’s domestic legislative capability and hence US fiscal policy will likely be frozen in place through 2025. In this report we provide a road map for the budget battle that will define the Biden presidency. Buy The Dip … Unless New Variants Change The Game First, a brief word regarding the COVID-19 pandemic. The Delta variant is ramping up, particularly in states where vaccination rates have lagged and social restrictions are minimal (Chart 1). The new lambda variant is also causing concerns that vaccines may be inadequate. Equity markets could easily suffer more downside in the near term but US-dedicated investors should consider the following: Scientists have created one vaccine for COVID-19 and can create others. There has been a concrete reduction in uncertainty since November 2020. Vaccination rates will never be perfect – many people smoke cigarettes and refuse to wear seat belts! – but greater infection rates and hospitalizations are leading to improvements in vaccination coverage. While new lockdowns are not impossible, the public will only support them as a last resort. Not only is the White House still officially opposed to new lockdowns but also the authority to impose lockdowns rests with governors. If hospital systems are crashing then even Republican governors will endorse new social restrictions. Otherwise, restrictions will not be draconian unless a much more virulent variant emerges (one that is more deadly or that has a worse impact on children). Monetary and fiscal stimulus will ramp up if a new variant is more deadly or the economy otherwise starts to slide back. In the US, additional fiscal stimulus will come faster than in other countries because new short-term measures can easily be tacked onto major bills that are already coming down the pike. Chart 1Stay Constructive Amid Delta Jitters Might the White House leverage a renewed sense of crisis to get its main fiscal bills passed? We can see that. The last thing Biden needs is a sluggish recovery to translate into congressional gridlock in the 2022 midterms – the bane of the Obama administration. Rather, the goal is to harness the sense of crisis to pass stimulus. Biden’s approval rating is falling, as is the norm with modern presidents. However, it is still “above water” (net positive) and still sufficient to get his legislative initiatives across the line. Biden’s forthcoming bills will reinforce economic recovery and sentiment (Chart 2) Chart 2Biden’s Approval Comes Down To Earth What if a variant evades vaccination? Especially if it is more deadly and/or more harmful to children? That would be a game changer and would cause at least a market correction. Still, investors would want to buy the dip given what they know today relative to what they knew in early 2020 (and given that they bought the dip in March 2020 even not knowing what they know today). Bipartisan Structural Reform Our second key view for 2021 – “bipartisan structural reform” – is coming to fruition with the Senate’s 69-30 vote passage of the American Infrastructure and Jobs Act as we go to press. Major bipartisan deals are rare in highly polarized America but we have given an 80% subjective chance of passage to this bill. Passage in the Senate reinforces that view, though the odds of final passage remain the same as there will be hurdles in the House. We include infrastructure as a “structural reform” because of its ability to increase the productivity of an economy. The bill contains funding for traditional infrastructure, like roads, bridges, and ports, as well as non-traditional infrastructure such as subsidies for electric vehicles and high-speed internet (Table 1). Table 1What’s In The Bipartisan Infrastructure Deal? Table 2 shows the 19 Republican senators who voted in favor of this bipartisan deal, along with their ideological ranking and state support rates. This tally provides a nine-seat buffer in case the House version of the bill requires another Senate vote. It also provides a measure of the support that might be brought to bear for bipartisan causes later, such as funding the government, suspending the debt ceiling, or passing bills on popular issues (such as regulating Big Tech) in 2022-24. All Democrats voted in unison for the bill. Table 2Republican Senators Who Voted For Biden’s Bipartisan Infrastructure Bill Our high confidence on infrastructure spending stems both from its popular support (Chart 3) and from the fact that even if bipartisanship fails, there remains a partisan option: budget reconciliation. This is still true today. The bipartisan infrastructure bill could still die in the House, given Speaker Nancy Pelosi’s determination to make its passage contingent on the success of the larger reconciliation bill, which is anathema to Republicans. But if it dies, Democrats would take up the key provisions in the reconciliation bill – and the odds of that bill passing would go up, not down, since Democrats would need to close ranks to clinch a legislative victory ahead of the midterms. Chart 3Popular Support For Bipartisan Infrastructure Deal Thus the real risk is not that infrastructure spending will fail but that its success will reduce the political capital needed to pass the more controversial reconciliation bill, which we discuss below. Over the short and medium term, this bipartisan infrastructure deal emblematizes the sea change in US fiscal policy – the shift against austerity – and thus serves to dispel fears of disinflation. At the same time, the deal epitomizes America’s long-term fiscal predicament. Democrats only want to increase spending while Republicans only want to decrease taxes. The former will not make budget cuts while the latter will not hike taxes. The result, inevitably, is higher budget deficits. This is precisely what occurred with the latest agreement: tax measures to pay for new infrastructure spending are mostly chimerical – the Congressional Budget Office (CBO) estimates that only $200 billion of the new spending will be offset with new revenue. The other $350 billion will add directly to deficits and debt. The difference is small but the political signal is notable. Chart 4 highlights the increase in the deficit likely to occur, with the CBO’s more realistic assessment delineated from the nominal bill. From a macro point of view, the takeaway is that the US economy faces a stark withdrawal of government support in 2022 but this bill slightly cushions the blow. Continued recovery will depend on consumers and businesses (which look to be in good shape). Beginning in 2025 deficits will start to rise again and hence the overall picture is one in which US government support for the economy has taken a step up for the decade. Chart 4Bipartisan Deal Not Paid For = Fiscal Stimulus Side note: Chart 4 is worrisome for President Biden if his reconciliation bill fails, as it points to fiscal drag through 2024, the election year. Bottom Line: We still see an 80% chance that Biden’s infrastructure proposals will pass, as the Democrats have a backup plan if the bipartisan deal somehow collapses in the House. Biden’s Greatest Legislative Battle Up till now we have assigned 50% odds of passage to the subsequent part of the Biden agenda, the American Families Plan, which covers social spending and tax hikes (corporate and individual). If bipartisan infrastructure passes promptly, we would upgrade the reconciliation bill’s odds of passing to 65%. The reason is twofold: first, reconciliation only requires a simple majority consisting of all 50 Senate Democrats plus the vice president; second, hesitant moderate senators ultimately will be forced to recognize that sinking the bill would render the Biden presidency defunct and fan the flames of populist rebellion on both sides of the political spectrum. And yet, since Biden cannot spare a single vote, conviction levels cannot be high. Therefore 65% seems appropriate. On August 9 Senate Democrats presented a $3.5 trillion budget resolution that will form the basis of the reconciliation bill this fall. The bill contains a wish list of spending priorities, as outlined in Table 3. Most of these are familiar from last month when the Senate Budget Committee first put forward its framework. The hang-up stems from House Speaker Pelosi. Knowing that infrastructure’s passage will suck away political capital from social spending, Pelosi is attempting to link the two bills. If the Senate fails to pass the reconciliation bill, the House will not pass the infrastructure bill. This gambit will create a big increase in uncertainty this fall as the legislative battle heats up. Republicans cannot support the infrastructure bill if it is directly tied to the Democrats’ “Nanny State” debt blowout, which will be the basis for their campaign against Democrats in future. They need plausible deniability. If Pelosi insists on linking the two bills, Republican support will evaporate. True, Democrats would then proceed to partisan reconciliation – but they would need to sacrifice other agenda items, such as subsidies for green tech, college, health care, and manufacturing (see Table 3 above). Table 3Senate Democratic FY22 Budget Resolution (July 2021) Biden and the Senate are now united on the infrastructure bill. Biden and Democrats in marginal seats need a legislative victory ahead of the midterms – and a bipartisan victory on a popular policy like infrastructure is critical. A bird in the hand is worth two in the bush. Therefore, Pelosi will probably have to concede, after gaining assurances from moderate Senate Democrats that they will not sink reconciliation. Moderate Democrats, in turn, will need to see the reconciliation bill watered down, both on spending and taxes. Table 4 shows both bills together, as Biden’s “Build Back Better” agenda, with a baseline net deficit impact. Budget deficit scenarios are then updated in Chart 5. Once again what stands out is the large fiscal drag in 2022, the fiscal thrust for the remainder of the decade, and (in this case) minimal fiscal drag for 2024. Table 4Face Value Impact Of Biden’s Spending Proposals Before Congress (Baseline) Chart 5Deficit Scenarios For Bipartisan Infrastructure Deal And Reconciliation Bill This is true even if tax hikes fail to make it into the final reconciliation bill. We still maintain that the corporate tax rate will rise above Senator Joe Manchin’s ideal 25% rate (if not all the way to Biden’s 28%) while individual tax rates will return to pre-Trump levels. It is not clear if capital gains tax hikes will make the final cut. Most likely some tax hikes will occur but they will fall short of Biden’s plan, producing, at most, a one percentage point increase in the budget deficit relative to the Congressional Budget Office’s baseline estimate (Chart 6). Chart 6What Happens If Tax Hikes Fail To Pass Congress? In Table 5 we update our various legislative scenarios, each consisting of different mixes of spending and tax hikes. We assume that the size of the bipartisan infrastructure deal will not be reduced in the House; that the revenue offsets of that deal will be $200 billion maximum; that moderate Senate Democrats will have greater success in watering down tax hikes than spending programs; and that the government overestimates its ability to collect revenue through tougher tax enforcement. Finally we assume that Senate Democrats’ spending proposals will not be cut – an extremely generous assumption that will not hold up in practice. Table 5Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill Each legislative scenario’s impact on the deficit is shown in Table 6. The result is a wide range of deficit impacts, from the baseline of $588 billion to Scenario 6, with $2.59 trillion (zero tax offsets). The more realistic range is from $1 trillion to $2.3 trillion (i.e. all scenarios except the baseline and Scenario 5). Within this range the result depends on the moderate senators’ negotiation skills. Conservatively, the impact will range from $1-$1.5 trillion (Scenarios 1, 2, 4), with moderate senators preventing a $2 trillion price tag as politically impracticable (e.g. Scenario 3). Table 6Scoring Of Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill There are two other aspects of Biden’s massive legislative battle this fall: regular government budget appropriations and the debt ceiling. Government appropriations are supposed to be passed by the end of the fiscal year, September 30, but often run over and likely will this time. Republicans will not support regular spending increases given that Democrats will ram through a partisan spending blowout. Therefore Congress will have to settle for a continuing resolution (a stop-gap measure) that keeps spending levels the same. Otherwise a government shutdown will occur. A shutdown is possible but would weigh heavily on Republicans’ public image, which is already at a low point in recent memory following the scandals of the Trump presidency. That is not all – there is also the debt ceiling (limit on national debt). Democrats made a major gambit by not including a suspension or increase of the debt ceiling in their fiscal 2022 budget resolution. If they had included it, then they could have raised the debt ceiling on their own with a simple majority when they passed their reconciliation bill. Instead they are attempting to make Republicans share the blame. Republicans, however, will mount an aggressive resistance, as they do not want to be seen as authorizing the debt increase necessary to accommodate the Democrats’ “socialist” spending spree. The “X date,” when the Treasury Department runs out of the ability to use extraordinary measures to make payments due on US debt, is expected sometime in October or November, though Treasury Secretary Janet Yellen warns it could come sooner and will try to pressure lawmakers. After this date the US would technically default on national debt obligations, triggering financial turmoil and potentially a global crisis. A debt ceiling showdown is virtually inevitable and volatility will rise – but ultimately a default will be averted, as we outlined in a recent report. First, Democrats still have the ability to revise the budget resolution so as to include a debt ceiling suspension in their final reconciliation bill. While Republicans could arguably block this attempt via a filibuster in the Budget Committee, they would have no interest in doing so (they could abstain and thus keep their hands clean of any debt ceiling increase). Second, Republicans can be forced to agree to a suspension of the debt ceiling when they fund the government, since it is necessary to do so anyway to fund their own infrastructure deal. Suspending the debt ceiling is not the same as raising it. New battles would be set up for later, in 2022 and beyond. But Republicans do not have the political ability to force a default on the public debt of the United States in the same year that Democrats accuse them of raising an insurrection against its Congress. Bottom Line: This fall will see the great legislative battle of the Biden presidency. Infrastructure spending has an 80% chance of passing. Pelosi will not be able to withstand Biden and the Senate in passing this deal separately from the more partisan reconciliation bill. If it passes, then Biden’s reconciliation bill will rise from 50% to 65% odds of passage. The latter will be watered down to a net deficit impact of $1-$1.5 trillion to secure the votes of moderate Senate Democrats, who ultimately will not betray their party to neuter Biden’s presidency. Thin margins in the House and Senate do not permit higher odds of passage or a high level of confidence. Investment Takeaways Political polarization has fallen sharply (Chart 7). This is connected to our view that the Republican Party is split, while Biden’s key initiative (infrastructure) has bipartisan support. However, Biden’s bipartisanship has resulted in a larger loss of Democratic support than a gain of Republican support (Chart 7, bottom panel). And the upcoming reconciliation bill will reignite Republican opposition. Moreover, polarization will remain at historically elevated levels, even to the point of generating domestic terrorist attacks, as we have argued. Biden’s approval rating has fallen but not enough to sink his legislative proposals. The overall economy is strong judging by both consumer confidence (Chart 8) and capital spending (Chart 9). Any soft patch in the economy in the near term will assist Biden in his legislative battles. Passage of either or both major bills will boost his approval rating, potentially ameliorating the Democrats’ challenging situation in the 2022 midterms. Chart 7Bipartisan Biden Lowers Polarization As Dems Waver Chart 8US Consumer Confidence Soars Chart 9US Capital Spending At Peak Levels Still, we expect investors to “buy the rumor and sell the news” of Biden’s upcoming stimulus bills. After the Senate passes the reconciliation measure, investors will have to look forward to the combined impact of tax hikes, the Fed’s tapering of asset purchases and eventual rate hikes, and the various troubles with global growth and geopolitical risk. Until that time, investors must weigh the risks of the COVID-19 variants against actions by both American and Chinese policymakers to dispel deflationary tail risks. Thus for now we are sticking with our key trades of the year: value stocks, materials, and infrastructure plays (Chart 10). After Biden wins his big legislative battles, we will reassess.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 10Buy Rumor, Sell News On Biden Plan   Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes    

In this Sector Insight report, we come back to the issue of “how much inflation is too much” for equities. The short answer is – equities don’t mind inflation as long as the Fed does not mind it either. Chart 1 shows historical analysis of forward SPX returns (both real and nominal) using different inflation ranges as a starting point.  Empirically, CPI prints of below 3% do not weigh on market performance.  However, once inflation rises above the 3-4% range, it causes a notable slowdown in returns, and above the 4% mark, it results into negative expected forward returns. Chart 2 is a scatterplot of trailing PE multiples vs core CPI prints.  This chart confirms our initial conclusion that an inflation sweet spot for the equity market is around 2-3% core CPI range: this is the range where equity multiples expand the most. It is also clear from the chart that any higher core CPI values become a headwind for equities. The implication is that the negative forward expected return that we showed on Chart 1 comes from the multiple contraction. Chart 1Moderate Inflation Does Not Have An Adverse Effect On The Performance Of Equities Chart 2High Levels Of Inflation Are Associated With Multiple Contraction Equities are a real asset, and rising inflation does not have a negative effect on the earnings, as most companies are able to pass cost increases to their customers, and strong earnings growth translates into robust equity returns. Inflation is a concern for equity investors only from one angle: higher inflation may provoke the Fed to raise rates, and higher rates do have an adverse effect on the performance of equities. Bottom Line: Our view remains that inflation surge was transitory, but we do believe that the inflation will stay elevated for a while. Yet, if it does not exceed the 3% mark, there will be no negative repercussions for equities if the Fed stays patient.