Equities

Weekly Performance Update For the week ending Thu Jun 17, 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 -2.34% -0.37% Top Contributors   WAT:US IT:US PSA:US KOF:US MPLX:US Weekly Return 12 bps 4 bps 2 bps 1 bps 0 bps Top Detractors   TX:US SCCO:US STX:US LPX:US AN:US Weekly Return -38 bps -33 bps -27 bps -14 bps -13 bps Top Prospects   TX:US BRK.A:US ESGR:US ANAT:US UHAL:US BCA Score 99.09% 98.99% 97.29% 96.86% 96.54% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI -0.74% 0.54% Top Contributors   TOY:CA CSU:CA CPX:CA TCN:CA DSG:CA Weekly Return 14 bps 11 bps 9 bps 9 bps 8 bps Top Detractors   CS:CA PXT:CA TCL.A:CA LNR:CA IMO:CA Weekly Return -43 bps -29 bps -19 bps -19 bps -18 bps Top Prospects   CS:CA LNF:CA IFP:CA RUS:CA CFP:CA BCA Score 99.79% 98.75% 98.48% 98.39% 96.94% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI -0.22% 0.94% Top Contributors   OXIG:GB POLR:GB CVSG:GB AAF:GB AGRO:GB Weekly Return 21 bps 16 bps 15 bps 10 bps 8 bps Top Detractors   FDEV:GB HSBK:GB SVST:GB DRX:GB VVO:GB Weekly Return -36 bps -14 bps -13 bps -11 bps -10 bps Top Prospects   SVST:GB GLTR:GB NLMK:GB RMG:GB BPCR:GB BCA Score 99.77% 98.61% 98.37% 97.91% 96.67% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI 0.12% 1.27% Top Contributors   STR:AT PHA:FR AOF:DE GTT:FR EDNR:IT Weekly Return 22 bps 19 bps 13 bps 12 bps 8 bps Top Detractors   SOLV:BE CEM:IT MMT:FR TKA:AT MS:IT Weekly Return -11 bps -8 bps -8 bps -7 bps -7 bps Top Prospects   STR:AT SOLV:BE POST:AT CNV:FR BB:FR BCA Score 99.02% 98.56% 98.44% 97.93% 97.52% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI 0.90% 0.35% Top Contributors   2791:JP 4966:JP 3132:JP 6676:JP 7994:JP Weekly Return 32 bps 31 bps 27 bps 19 bps 18 bps Top Detractors   8117:JP 8850:JP 3291:JP 8595:JP 6345:JP Weekly Return -14 bps -13 bps -12 bps -11 bps -10 bps Top Prospects   5930:JP 3291:JP 4966:JP 9436:JP 7994:JP BCA Score 99.48% 98.95% 98.66% 98.34% 98.32% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI 0.79% -0.61% Top Contributors   990:HK 3600:HK 857:HK 215:HK 1919:HK Weekly Return 58 bps 51 bps 21 bps 18 bps 15 bps Top Detractors   1258:HK 2877:HK 2768:HK 323:HK 743:HK Weekly Return -25 bps -19 bps -15 bps -12 bps -11 bps Top Prospects   990:HK 1606:HK 2232:HK 86:HK 116:HK BCA Score 98.85% 98.22% 97.78% 97.60% 97.38% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI -0.99% 0.56% Top Contributors   JLG:AU FLN:AU NEW:AU PL8:AU ELD:AU Weekly Return 24 bps 21 bps 16 bps 8 bps 8 bps Top Detractors   PDN:AU GRR:AU CIA:AU SRV:AU CAJ:AU Weekly Return -50 bps -23 bps -18 bps -17 bps -13 bps Top Prospects   GRR:AU PIC:AU CIA:AU BFG:AU BLX:AU BCA Score 98.90% 98.01% 97.03% 96.38% 96.21%

Special Report

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism Chart 3China Catching Up To Cuba On Basic Wellbeing What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ Chart 4China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating Chart 5BChina’s Demographic Decline Accelerating In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Highlights New variants of SARS-Cov-2 will create new waves of infection, the inflation bubble is bursting, and massive slack in the US labour market will keep US inflation structurally subdued. The coming years will be defined by a trifecta of surging productivity, massive slack in the labour market, and ultra-low inflation.  Overweight US T-bonds both tactically and structurally. Equity investors should overweight growth versus value… …overweight defensives versus cyclicals… …overweight the US versus the euro area… …and overweight DM versus EM, both tactically and structurally. Tactically underweight US REITS. Tactically overweight Nike versus L’Oréal. Feature Chart of the WeekThe Global Pandemic Is Still In Flow The UK will have to wait for its ‘freedom day.’ Lifting the remaining pandemic-related restrictions has been postponed because a new and more vaccine-resistant ‘delta’ variant of the virus is threatening to unleash a third wave of UK infections. The UK experience is important because it was the first major developed economy to roll out its mass vaccination program. Thereby, the UK experience could be the harbinger of things to come in other major economies like the US and the euro area. Vaccines Against RNA Viruses Are Not Highly Effective The general public and financial markets have high expectations that mass vaccination programs can banish Covid forever. Such expectations are unrealistic, just as it is unrealistic to expect vaccinations to banish the flu forever. It is unrealistic to expect vaccinations to banish Covid forever. Covid, the flu, and measles are all diseases caused by ‘RNA viruses.’ The defining characteristic of RNA viruses is their poor proofreading ability during replication, resulting in high rates of mutation. The resulting variant strains make RNA viruses highly effective at evading vaccinations. As the Journal of Immunology Research puts it:1 “No vaccine or specific treatment is available for many of these RNA viruses and some of the available vaccines and treatments are not highly effective.” Measles is an exception because its virus is ‘antigenically monotypic.’ The spike proteins (antigens) that the measles virus uses to infect a cell cannot mutate even slightly without breaking. However, the SARS-CoV-2 spike proteins can mutate and still infect. This we know because the virus has already evolved several infectious variants – including the latest delta variant – with increasing abilities to evade the current spike-based vaccines (Figure I-1). Figure I-1How Variants Of SARS-CoV-2 Evade Spike-Based Vaccines SARS-Cov-2 doesn’t care who it infects or in which country they live. Sadly, the pandemic has claimed more fatalities in the first half of 2021 than in the whole of 2020 (Chart of the Week). And the virus will continue to mutate liberally given that its reproduction rate is still close to 1 (Chart I-2).   Chart I-2The Reproduction Rate Is Still Close To 1 Crucially, the mutations of the virus that evade vaccinations are the ones that are more likely to spread and become the new dominant strains. After the delta variant will come the epsilon variant, the zeta variant, the eta variant… and so on until we run out of Greek alphabet. In which case, should we just adopt the same strategy for Covid as we use for the seasonal flu – remove all pandemic-related restrictions, while offering booster vaccinations to the most medically vulnerable once or twice a year? There are two problems with this strategy: First, it could still overwhelm our healthcare systems during surges in demand. This we know because a bad flu season, by itself, was already pushing some healthcare systems to the limit. There is very little spare capacity to cope with additional demand. Second, unlike the flu, Covid appears to have long-term sequelae, colloquially called ‘long Covid’ with unknown chronic damage to health. As the Lancet points out: “Long-term sequelae of Covid-19 are unknown… we owe good answers on the long-term consequences of the disease to our patients and healthcare providers” Without these answers, policymakers cannot adopt the same strategy for Covid as for the flu. So yes, we can certainly offer vaccinations to the most medically vulnerable once or twice a year. But managing infections will also require non-pharmaceutical interventions, dialled up and down based on the severity of future waves of infection. A Productivity Super-Boom Is Coming Periodic non-pharmaceutical interventions which include restrictions to national and international movement will be around for much longer than the general public and financial markets expect. This will solidify a more remote way of working, shopping, interacting, and doing business. The good news is that this will create the mother of all productivity booms. Productivity tends to surge after every recession. This is because the period immediately after a recession is when the economy experiences the most intensive clearing out of dead wood, restructuring of capital and labour, and absorption of new technologies and ways of working. The pandemic has forced nearly every company and every worker to adopt new technologies and ways of working and living. But whereas most recessions upend one or two sectors of the economy, the pandemic has upended all sectors – forcing nearly every company and every worker to adopt new technologies and ways of working and living. This will make the pandemic productivity boom a super-boom unlike anything experienced in recent history (Chart I-3). Chart I-3The Pandemic Productivity Boom Will Be A Super-Boom The unfortunate corollary of this productivity super-boom is that the pace of absorption of the excess unemployed and inactive will be slower, meaning that it will take a long time to reach the goal of ‘full employment’ (Chart I-4). Chart I-4It Will Take A Long Time To Reach 'Full Employment' In the US, the Federal Reserve is acutely aware of this. As Jay Powell has pointed out: “It’s going to be a different economy. We’ve been hearing a lot from companies looking at deploying better technology and perhaps fewer people, including in some of the services industries that have been employing a lot of people. It seems quite likely that a number of the people who had those service sector jobs will struggle to find the same job, and may need time to find work” Without full employment, it will be difficult to maintain US inflation at or above the Fed’s 2 percent target. The transmission mechanism is that the (permanent) unemployment rate establishes the ability to pay rent. Thereby, it is the main driver of ‘rent of shelter’, which comprises almost half of the core consumer price index. Empirically, unless rent of shelter inflation gets to 3 percent and remains there, it will be very difficult for core inflation to remain at over 2 percent (Chart I-5 and Chart I-6). For reference, rent of shelter inflation is now running well short of 3 percent, at 2.2 percent. Chart I-5Full Employment Is Needed To Lift Rent Inflation To 3 Percent... Chart I-6...And Rent Inflation At 3 Percent Is Needed To Keep Core Inflation At 2 Percent In a nutshell, the coming years will be defined by a trifecta of surging productivity, massive slack in the labour market, and ultra-low inflation. Overweight Growth, And Overweight The US Given that new variants of the virus will create new waves of infection, that The Inflation Bubble Will Burst, and that the massive slack in the labour market will keep inflation structurally subdued, investors should own US T-bonds both tactically and structurally. There is massive slack in the US labour market. Furthermore, The Pareto Principle Of Investment tells us that if you get the direction of the bond yield right, you will get your whole investment strategy right. Declining bond yields boost growth stocks. This is because the ‘net present value’ of cashflows that are weighted deep into the future are highly leveraged to a falling discount rate. In addition, the productivity super-boom will be facilitated by technology and new economy sectors. As such, equity investors should avoid value, and steer towards growth, both tactically and structurally (Chart I-7). This extends to overweighting defensives versus cyclicals, overweighting the growth-heavy US versus the value-heavy euro area, and so on. In effect, all these positions are just one massive correlated trade (Charts I-8-Chart I-11). Chart I-7Structurally Overweight Growth Versus Value Chart I-8Correlated Trades: Bond Price, Growth Versus Value... Chart I-9...Tech Versus ##br##Market... Chart I-10...Defensive Versus Cyclical... Chart I-11...And US Versus Euro Area These sector preferences also imply an overweight to developed markets (DM) versus emerging markets (EM). Tactically Underweight US REITS, And Tactically Overweight Nike Versus L’Oréal Finally, and corroborating the preceding sections, the rally in ‘reopening plays’ has become fractally fragile. One way to play this tactically is to underweight US REITS (Chart I-12). Chart I-12'Reopening Plays' Are Fractally Fragile: US REITS But our preferred tactical expression is to overweight Nike versus L’Oréal (Chart I-13), setting the profit target and symmetrical stop-loss at 9 percent. Chart I-13'Reopening Plays' Are Fractally Fragile: L'Oreal Versus Nike   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Journal of Immunology Research, Volume 218: Immune Responses to RNA Viruses, by Elias A. Said Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - 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  

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss the outlook for China’s economy and financial markets, a year into policy normalization. The webcasts will be held on Tuesday, June 22 at 10:00 am EDT (English), and Thursday, June 24 at 9:00 am HKT (Mandarin). We will return to our regular publishing schedule on Wednesday, June 30. Best regards, Jing Sima, China Strategist   Feature China’s onshore stocks rebounded in the past two months on the back of a rapidly appreciating RMB versus the US dollar and accelerating foreign capital inflows (Chart 1). However, in our view, China’s domestic policy backdrop and economic fundamentals do not support a sustained rally in Chinese stocks in the next six months. The RMB’s rise vis-à-vis the US dollar will likely falter in the second half of the year as China’s growth weakens. A narrowing in real yields later this year between China’s government bonds and US Treasuries will also discourage foreign flows into Chinese assets. Performance of Chinese cyclical stocks versus defensives failed to decisively breakout in both the onshore and offshore equity markets. An underperformance in cyclical stocks relative to defensives has historically pointed to waning market sentiment towards the Chinese economy (Chart 2). Chart 1Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Chart 2Cyclical Stocks Continued To Underperform Defensives The number of onshore stocks with prices rising versus falling remains low, even though there has been a slight improvement this year from Q4 2020. The narrow breath in the equity market implies that recent rebound in A-share stocks has been largely driven by a handful of companies (Chart 3). Such narrow breadth suggests that the rebound in Chinese stock prices will not sustain (Chart 4). Chart 3A Narrow-Based Market Rally in A-Shares Chart 4Narrowing Market Breadth Has Historically Led To Price Pullbacks A tightened monetary and credit environment has created obstacles for Chinese equities since early this year. Credit numbers released last week show that credit growth deceleration has gathered speed in May, raising the risk of policy overtightening, i.e. credit growth undershooting the government’s 2021 targets. We could see some moderation in the credit growth deceleration into 2H21. A delay in the rollout of local government (LG) bonds and LG special purpose bonds (SPBs) in the first five months of the year means the pace of LG bond issuance between June and October will escalate, which will help to stabilize credit growth. However, weak corporate bond net financing and contracting shadow banking will cap the upside in credit expansion. Chart 5The Economy Could Surprise The Market To The Downside In Q3 Additionally, if more LG bonds come onto the market in Q3, then we could see tighter interbank liquidity conditions and higher bond yields. This, in turn, would partially offset the positive effects on the economy and equity market from a slower pace in credit growth deceleration. For the next six months, we continue to hold an underweight position in Chinese onshore and investable stocks, in both absolute terms and within a global equity portfolio. Policy tightening has not reversed course and there is an escalating risk that economic data will surprise the market to the downside in Q3 (Chart 5). Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com     Macro Policy Conditions Are Still Unfavorable For Risk Assets A further deterioration in the credit impulse in May reflects Chinese authorities’ efforts to reduce local government leverage and shadow banking activities. Net corporate bond financing contracted for the first time since early 2018, driven by shrinking local government financing vehicle (LGFV) bonds (Chart 6). Meanwhile, the pace of contraction in shadow-bank loans climbed. At this rate of deceleration, credit growth will undershoot the government’s 2021 target, which is expected to be in line with this year’s nominal GDP growth. The pace in credit expansion on a year-over-year basis has dropped to its previous cycle’s trough (Chart 7). Moreover, the speed of the deceleration in credit growth has outpaced the 2017/18 tightening cycle. It has been seven months since Chinese credit growth peaked (October 2020), which is significantly less than the 13 months it took for credit to decline from top to bottom in 2017/18. Chart 6Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Chart 7Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Chart 8Most Of LG Bonds Issued In The First Five Months Are Refinancing Bonds So far this year, LG bond issuance is also behind schedule. About 63% of LG bonds issued in the first five months are refinancing bonds (Chart 8). The new LG bonds and LG SPBs issued to date account for only 21% and 16.5%, respectively, of their 2021 quotas. A delay in LG bond issuance in the first five months means that much more bonds will be on the market between June and October, which may help to stabilize credit growth in Q3. However, weak corporate bond financing and an acceleration in contracting shadow banking activities will cap the upside on broad credit. We do not expect a reversal in policy tightening. Instead, credit growth will likely hover near current levels for the rest of the year. In the past, Chinese policymakers eased when the global manufacturing backdrop faltered. Given that global growth is robust, Chinese policymakers will not feel any urgency to reverse policy setting and will likely use the strong external environment as an opportunity for domestic deleveraging. Chinese Exports Will Face Challenges In The Second Half Of The Year Chart 9A Broad-Based Moderation In China's Exports to DMs Export growth slowed in May with a broad-based moderation in the country’s exports to developed markets (DMs), albeit from a very elevated level (Chart 9). The easing in exports reflects an ongoing demand shift in the DMs away from goods to services as economic activity normalizes (Chart 10). China’s robust exports, which have been driven by strong and partly pandemic-induced global demand for goods, will likely gradually lose strength in the second half of the year. China’s weakening new export orders component in the May manufacturing PMI reflects this trend (Chart 11). Chart 10Global Consumption Recovery In Services Will Likely Outpace Goods Chart 11China's Softening New Export Orders Signal Further Export-Sector Weakness An appreciating RMB versus the US dollar is also a headwind for Chinese exports. The USD/CNY historically has led Chinese new export orders by around six months, with the exception of the pandemic-hit outlier in 2020 (Chart 12).  The recent sharp RMB appreciation is starting to weight on Chinese exports. Moreover, BCA’s Geopolitical strategists do not expect that China will principally benefit from US President Biden’s $2.4 trillion infrastructure and green energy plan . US explicitly aims to diminish China’s role as a supplier of US goods and materials. The widening divergence between US’s trade deficit with China and the rest of world already shows evidence (Chart 13). Chart 12The RMB's Rapid Rise Creates Headwinds For Chinese Exports Chart 13China's Exports May Not Benefit From Biden's Infrastructure Plan Still No Inflation Pass-Through Chart 14Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese surging producer prices overstate domestic inflationary pressures. Inflation in the Producer Price Index (PPI) surged by 9.0% year-over-year in May, jumping to its highest level since 2009. High PPI inflation reflects rising commodity prices and a low base effect. Meanwhile, inflationary pressures are much more muted for consumer goods and services. The gap between producer and consumer prices widened to the highest level since 1990, highlighting the absence of price inflation pass-through from producers to consumers (Chart 14). We expect soaring PPI inflation to be transitory; it will ease when low-base factors from last year and global supply constraints are removed later this year. CPI inflation will remain tame through the year. As such, Chinese authorities are unlikely to tighten monetary policy in response to high PPI readings. Instead, Beijing will continue to use regulatory measures to curb speculation in the commodity market and window-guide industries to readjust material inventories to help ease the pace of rising commodity prices. Historically, PPI inflation’s impact on consumer prices has been weak when prices on producer goods were pushed up by supply shocks rather than mounting domestic demand. The sharp uptick in the PPI during the 2017/18 cycle was mostly due to China’s supply-side reforms and a rapid consolidation in the upstream industries. Global supply constraints linked to the pandemic have also resulted in a sharp upturn in the Chinese PPI since mid-2020. Moreover, Chart 15 shows that the pass-through from PPI inflation to consumers is closely correlated to household income growth. The pass-through has weakened significantly since 2011 when household income growth subdued along with a declining Chinese working population (Chart 16). Chart 15Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Chart 16Income Growth Decelerated After China's Working Population Peaked Chart 17Profits Diverged Between Upstream And Mid & Downstream Industries Lacking inflation pass-through from producers to consumers has led to a bifurcated profit recovery between upstream and mid & downstream industries. Since late last year, the share of upstream industries in total profits increased sharply at the expense of mid and downstream businesses (Chart 17). A deterioration in the profits of mid and downstream industries will weigh on the outlook for their capex, which in turn, will reduce the demand for upstream goods.     Domestic Demand Remains China’s Weakest Link Investments and household demand remain the weakest links in China’s economy. Sluggish household consumption reflects a fragile post-pandemic recovery in manufacturing and services employment, and a rising propensity for precautionary savings (Chart 18). A PBoC survey shows that households’ preference for more saving deposits soared in 2020 (Chart 19). Although it has slightly diminished since late 2020, the reading is still much higher than its pre-pandemic level and will likely persist to year-end on the back of a subdued outlook for employment and income. Chart 18Weak Employment In Both Manufacturing And Service Industries Chart 19Propensity For Precautionary Savings Is Still Elevated Manufacturing investment continued its rebound in April, but the growth has not rallied to its pre-pandemic state and the recovery was more than offset by falling old-economy infrastructure and real estate investment growth (Chart 20). Although a pickup in LG SPB issuance in Q3 will provide some support to infrastructure expenditures, the effect on aggregate infrastructure investment probably will be muted. China’s Ministry of Finance has raised the requirements for approvals of new investment projects, which have decreased notably since early this year (Chart 21). Hence, growth in infrastructure investment may not significantly improve in 2H21 without a harmonized policy impetus for more bank loans and loosened regulations on local government spending. Chart 20Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Chart 21Falling New Projects Approval Real Estate Sector: Mounting Deleverage Pressure Property developers face challenges from heightened government scrutiny on bank loans and limits on the sector’s leverage ratio, along with curtailed off-balance sheet funding due to Asset Management Regulation (AMR) . Bank loans to real estate developers and household mortgages have tumbled to historical lows and will likely slow further in the next few months (Chart 22, top panel). The tightened financing policies have started to cool demand in the real estate market (Chart 22, bottom panel). Softer housing demand will start to drag down property developers’ capital spending and real estate construction activities (Chart 23). Chart 22Deteriorating Financing Starting To Cool The Property Market Chart 23Real Estate Investments And Construction Activities May Slow Further   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights The US business cycle is shifting into a slowdown stage: US economic and earnings growth will remain robust but decelerate from their peak.  Treasury rates have stabilized, and inflation fears, if not dissipated, have become priced in.  The consumer is flash with cash, and pent-up demand has not yet faded.  Demand for services exceeds demand for goods.  Valuations are rich, and short-term consolidation is likely. Considering this market backdrop, we recommend a barbell positioning for equity portfolios – a combination of Growth and Cyclicals: Shift allocation towards stable growth sectors, such as Technology, which are getting a shot in the arm from rates stabilization and the growth slowdown. Take a granular approach to selection of cyclical sectors and industries, with preference for the ones most exposed to consumer pent-up demand for goods and services and to a revival of global trade flows. Differentiate between Value and Cyclicals:  Cyclicals are more “growthy” than run-of-the-mill Value sectors.   Feature In our report of June 7, 2021, we outlined our investment framework. In this report we apply our investment principles to analyze the state of the equity markets today and derive investment recommendations. Business Cycle Is Shifting Into A Slowdown Stage The pandemic is barely over, but the markets have already galloped through both the recovery and expansion stages of the business cycle on the back of economic reopening, fiscal and monetary stimulus, and pent-up demand (Table 1). Table 1Stages Of The Business Cycle We posit that the business cycle is at the crest of the expansion stage and is shifting into a moderate slowdown. While growth is to remain robust, it has most likely peaked and is starting to decelerate: The ISM Composite reading is elevated but has slipped from a high of 64.2 in March to 62.6 in June (Chart 1). According to Bloomberg consensus estimates, GDP growth is to slow from 6.4% in 2021 to 4% in 2022. The earnings cycle is also peaking. In Q1-2021 US equities delivered 53% YoY earnings growth. Going forward, expectations are for 21% (Chart 2). Chart 1ISM Composite Has Peaked Chart 2EPS Growth Has Also Peaked While earnings growth is expected to remain robust, a change in pace often manifests itself in a change of market leadership from Value to Growth. Prices Set To Rise But At A Slower Pace Since the beginning of this year, investors’ eyes have been fixed on rising inflation readings. The crux of the debate was centered on whether high inflation is here to stay or is a transitory phenomenon. While we don’t have a definitive answer yet, there is a sufficient body of evidence to suggest that inflation is likely to decelerate. First, the 5-year inflation breakeven has stabilized indicating that the market expects consumer price increases to moderate (Chart 3). Second, the recent spike in the inflation reading has been exacerbated by the base effect of comparison with the darkest days of the pandemic in March-May 2020. Inflation troughed in June of 2020, which will anchor this coming summer’s inflation numbers to a higher base. (Chart 4). Chart 3Inflation Breakeven Stabilized Chart 4Base Effects Of The Spring 2020 Are To Roll Off Third, inflation is likely to dissipate to more normal levels later in the year thanks to millions rejoining the labor force upon expiration of supplemental employment insurance benefits in the fall, and the supply chain gradually becoming unclogged. Last, the bubble in commodities prices has burst with prices of lumber, corn and steel coming down from their highs by more than 30%, keeping a lid on PPI, and subsequently on the price of finished goods (Chart 5 & Chart 6) . Chart 5Bubble In Commodities Burst Chart 6PPI To Follow Commodity Prices Rates Are Stabilizing After rising by nearly 1% from 0.5% to 1.5% in the course of just four months from November 2020 to February 2021, the 10-year Treasury yield has been range bound between 1.5% and 1.7% despite fireworks in the US economic data ranging from CPI readings to unemployment beats (Chart 7). The fact that the bond market is refusing to budge no matter how positive a macro release number we get, confirms our view that a post Covid-19 economic revival and accelerated growth have been priced in. Case in point: The Citi Economic Surprise Index (CESI) turned down from its February highs and is approaching zero. Chart 7Rates Are Range Bound Since March Given the tight positive correlation (44%) between CESI and UST10Y, and inflation moderating, it is unlikely that the bond market will enter another aggressive sell-off phase (Chart 8). It is possible that rates will continue to grind higher over the summer, but the rate of ascent, which is more important for growth-oriented assets than the level (excluding extreme readings), is likely to be slow. Chart 8Positive Economic Data Is Priced In Consumers Are Flash With Cash After a series of helicopter cash drops, most consumers came out of the recession in a better financial shape than they entered it. According estimates by Peter G Peterson Foundation, only 22% and 19% of second and third round of stimulus checks have been spent (in addition, some of the money was used to pay off debt). Personal savings have increased by roughly $1.5 trillion from January 2020 trough, and disposable income has increased by 6% (Chart 9). With plentiful jobs and quit rates off the map, we expect consumer confidence to remain high and support spending. The investment implication is that we favor parts of the equity market most exposed to American consumer. Chart 9Consumers Are Flash With Cash Services Are In Higher Demand Than Goods After months of consumer behavior altered by fears of the pandemic, economic reopening has brought about strong demand for services. Indeed, the latest Non-manufacturing ISM PMI reading was 64 compared to 61 for Manufacturing, which has clearly peaked. As a result, we favor service sectors, both in the consumer and industrial space (Chart 10). Chart 10Demand For Services Outstrips Demand For Goods Global Trade Flows Are Soaring The global push for vaccinations and pent-up demand have jump-started trade flows around the globe. Despite shipping bottlenecks and container shortages, global trade is thriving, strengthening demand for industrial goods and transportation services (Chart 11). Chart 11Global Trade Soars Valuations Are Elevated The US equity market had a fantastic run over the past year, delivering 93% return from March 2020 trough, and is now trading at 30x trailing PE. Forward-looking PE is also elevated at 23x. About 40% of S&P 500 industry groups are trading in the top 10% of their historical valuations. In a way, markets have borrowed returns from the future (Chart 12). With valuations close to an all-time high, equity markets do not have much safety margin and are vulnerable to a correction which may be triggered by hawkish rhetoric from the Fed, or upside inflation or employment surprises. Having said that, we are bullish on equity markets on a three to six months horizon. Chart 12US Equities Are Expensive Lastly, high valuation is not necessarily an impediment to a continued bull market but more of a speed limit: Returns of US equities are to be modest going forward. To keep portfolio return volatility down and enhance compounding effects, we recommend carrying a healthy allocation to such defensive sectors as Health Care. We would stay away from bond proxies like Utilities and Telecom. Investment Implications To sum it all up: Economic and earnings growth is to remain robust but come down from the peak, inflation is to decelerate but stay high, rates are to remain stable, consumer spending is to stay robust, demand for services is to exceed demand for goods and global trade flows are soaring. What do these economic developments mean for portfolio positioning? What styles and sectors will fare best in the current economic environment? Growth does well when rates and inflation are stabilizing thanks to the long duration nature of its earnings stream, and shines in a slowdown when growth becomes scarcer. Cyclicals thrive in an environment of falling inflation, but a mature cycle is not an ideal backdrop for their outperformance. In terms of sector selection, we favor Cyclicals with exposure to consumers, playing growth through the “new economy”, i.e. Software and Services, and Internet Retailing. We will fund the new positions by taking profits from recent winners, Financials and Materials. The following is a brief rationale for these allocations. Value/Growth Rotation Between November 5, 2020 and May 7, 2021, long-duration Growth equities underperformed Value equities by 16%, beaten down by rising rates and accelerating economic growth. However, recently the case for Growth has strengthened. With rates stabilizing and inflation decelerating, there are already early signs that Growth stocks are staging a comeback, outperforming Value by 2.5% since May 10. Chart 13 shows that, in an enviroment of slowing inflation, Growth tends to outperform Value (Chart 14). Chart 13Growth Underperforms Value Since October 2020 Chart 14Growth Has Outperformed When Inflation Decelerates Further, peak economic and earnings growth, as well as the business cycle moving into a slowdown stage, bode well for Growth sectors (Chart 15). Chart 15Growth Shines In A Slowdown Stage Chart 16Growth Is Less Frothy Now Further, zooming into fundamentals and valuations, we observe that Growth stocks remain expensive, trading at a forward multiple of 27x, which is a 53% premium to Value, but some of the froth has come off as the style is now trading 3 points lower than back in December 2020 (Chart 16). Comparing Growth and Value earnings expectations, Value stocks are expected to grow about 10% faster than Growth stocks (Chart 17). The crux of the current Growth/Value dilemma is that, while optically Value is more attractive: cheaper than Growth and offering higher earnings growth, it is also much more sensitive to a slowdown in economic growth and rates stabilization (even if rates remain high). Thus, if we are right and rates and inflation have indeed steadied, and growth is slowing. Growth will outperform Value despite the latter’s superior fundamentals. The explanation lies in a sector composition of the two styles. Value’s top allocation is Financials, for which stabilizing rates and a flattening yield curve are detrimental. Growth’s top allocation is Information Technology (40% of the index), which thrives in an environment of lower growth and stable rates (Chart 18). All in all, we recommend topping up Growth sectors in a portfolio to be better positioned for an imminent change in regime. Chart 17Value Is Expected To Have Higher Earnings Growth Chart 18Growth Is Exposed To Tech, Value To Financials Cyclicals Vs Defensives Similarly to Value, Cyclicals have outperformed Defensives by about 10.7% since November. However, in March this rally ran out of steam, and relative returns remain range bound Chart 19. Further, performance of Cyclicals is sensitive to the stages of the business cycle. Normally, in a slowdown stage, Cyclicals lag. Chart 20 shows performance of Cyclicals during the slowdown stage of the business cycles. Chart 19Cyclicals Have Not Outperformed Defensives Since March Chart 20Slowdown Regime Doesn’t Favor Cyclicals However, this cycle may turn out somewhat different due to supply-chain disruptions and pent-up demand. Many of the conditions supporting Cyclicals are still in place: The potential infrastructure package, improving global trade and easy financial conditions. Earnings expectations relative to Defensives remain robust, and valuations have recently compressed from a 97% premium in February 2021, to 17% in May (Chart 21). Hence, we are not yet ready to give up on Cyclical stocks but will be granular in our allocations, favoring industry groups most exposed to services, global trade, infrastructure, and the US consumer. Chart 21Cyclicals Have Rerated Rel To Defensives Are Cyclicals The Same As Value? The reader may observe that we favor Cyclicals over Value and wonder if they are not one and the same. While recently Value and Cyclicals have been nearly 90% correlated (Chart 22), this relationship changes over time. Cyclicals have higher exposure than Value to stable growth sectors like Technology, and Consumer Discretionary (Chart 23). We prefer Cyclicals to Value because Technology is a quintessential growth sector favored by the current macroeconomic backdrop, and the Consumer Discretionary sector is exposed to increases in discretionary income and consumer demand for services. Choosing between Value and Cyclicals, we pick Cyclicals (Chart 23). Chart 22Relationship Between Value And Cyclicals Changes Over Time Chart 23Cyclicals Have More Exposure To Stable Growth Than Value  Investment Recommendations Overweight Growth-Oriented And Cyclical Sectors Growth-oriented industries groups and industries benefiting from rate stabilization, such as Software and IT Services, Semiconductors, and Internet Retail. Valuations are expensive but are justified by strong expected long-term earnings growth. Cyclical industries exposed to consumer demand for services and experiences, such as Hotels, Restaurants, Entertainment, and Airlines. Discretionary goods industry groups such as Autos & Components, and Consumer Durables. Industrial service-oriented industry groups, such as Transportation and Professional Services Global trade and infrastructure exposed industries such as Transportation, Construction and Engineering, and Building Materials. Equal Weight Defensive Sectors Health care valuations and returns have been subdued due to disruptions wrecked by the pandemic. However, in addition to trading at 16x forward earnings, the sector expects solid earnings growth (10% over the next 12 months) and is likely to benefit from post-Covid-19 normalization in health care and diminished policy risks. To be more specific, policy risk for Big Pharma is higher as it is a bipartisan target, while managed health care got a big positive policy surprise when Biden wisely decided earlier this year not to re-fight the health care battles of the Obama administration. Underweight Sectors Negatively Affected By Rate And Inflation Stabilization (Off High Levels) Rate stabilization and yield-curve flattening is detrimental to rate-sensitive sectors such as Banks and Insurance. Inflation deceleration will be detrimental to industry groups with high pricing power and high exposure to raw materials. Since commodities prices have rolled over, the Metals and Mining industry group may take a pause. We will also avoid bond-proxy sectors like Utilities and Consumer Staples: Rates have stabilized but a bull market in bonds is highly unlikely Bottom Line Peak growth, inflation and rates stabilization herald a new lease of life for Growth stocks. Strong consumption and pent-up demand for goods and services as well as a revival of global trade support further outperformance of Cyclicals.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights The ECB did not tighten policy, despite its upgrade to the Euro Area growth outlook. The rise in the Eurozone inflation will be transitory. The Euro Area continues to suffer from excessive slack, and current price pressures are narrow. The ECB rightfully worries about tightening financial conditions by prematurely removing monetary accommodation. The ECB does not want to move ahead of the release of its Strategy Review. Global growth is likely to experience a temporary hiccup this summer. The ECB will only taper its PEPP program in Q1 2022 with no firm announcement until Q4 2021. Stay overweight European peripheral bonds. Despite a favorable 18-month outlook, European cyclical equities face pronounced risks this summer. Investors should raise cash levels for now to keep dry powder for this fall. Feature At its policy meeting last week, the ECB refrained from adjusting policy. While the euro and bund yields barely budged on the news, Italian and Greek spreads narrowed a few basis point, welcoming the dissipating risk of decreased bond purchases. The ECB’s decision is in line with the analysis we published two weeks ago, which argued against the Governing Council hinting at a tapering of asset purchases at its June meeting.  Growing signs that the expected pick-up in the Eurozone inflation will be transitory and that China’s credit slowdown will negatively impact Europe increase our confidence that the ECB will not announce any adjustment to its asset purchases until the fourth quarter of 2021. This setup supports European peripheral bonds. However, it also points to a correction in European cyclical stocks. The ECB Announcement ECB President Christine Lagarde highlighted the need for a steady hand, with no policy change. The risks to growth are now “broadly balanced,” but enough uncertainty remains that removing accommodation too early still creates a much poorer risk/reward trade-off than maintaining the current policy. The ECB boosted its growth forecast in 2021 and 2022. As Table 1A illustrates, 2021 GDP growth was raised to 4.6% from 4% in March, and 2022 GDP growth was raised to 4.7% from 4.1%. Activity was left unchanged at 2.1% in 2023. The ECB and this publication are on the same page; Euro Area domestic activity will enjoy a welcomed fillip as a result of the re-opening of the economy, a response to the improving pace of vaccination across the continent. Moreover, the NGEU program will start disbursing funds this summer and will add another boost to growth. Despite this significant upgrade to anticipated growth, the ECB kept its accelerated pace of asset purchases in place, at least through the summer, because the inflation outlook remains below its target of “close but below 2%” durably. As Table 1B shows, the ECB expects HICP to hit 1.9% in 2021, but it will subsequently slow to 1.5% in 2022 and 1.4% in 2021. Table 1AUpgraded Growth Forecast Table 1BBelow Target Inflation Bottom Line: The ECB did not taper its PEPP purchases, because of uncertainty and below-target inflation. Too Many Deflationary Risks The policy stance of the ECB is appropriate on three levels. First, the case for Eurozone inflation to be transitory is even stronger than it is in the US. Second, financial conditions could easily deteriorate if the ECB were to tighten policy too early. Finally, the Strategy Review due this fall further paralyzes the ECB for now. Transitory Inflation Headline and core CPI in the Eurozone will increase significantly in the coming months but will slow next year. The ECB’s core CPI measure, which excludes food and energy, is set to rise above the levels of the past 15 years. As the US re-opened, core CPI spiked on both yearly and monthly bases. The presence of bottlenecks across domestic and global supply chains indicates that the Euro Area will experience a similar outcome. Assuming that monthly inflation rates will settle between 0.2% and 0.25% for the remainder of 2021, by year’s end, annual inflation will stand between 2% and 2.5% (Chart 1). The European PMI indices confirm the upside for the Euro Area’s core inflation. Service inflation has been more stable than in the US, but goods inflation is rising in line with the higher manufacturing PMI (Chart 2). Services inflation will accelerate according to the services PMI. Chart 1Higher Inflation For 2021 Chart 12Accelerating Goods And Services Inflation   Surveys confirm that this summer’s re-opening will jumpstart inflation. The employment components of both the European Commission’s Retail and Services Surveys are consistent with a rapid pickup in employment (Chart 3). This will support household income and consumption. Additionally, the EC’s Consumer Survey indicates that European households are ready to increase their purchase of homes and cars compared to last year (Chart 3, bottom panel). When stronger demand meets supply bottlenecks, higher prices ensue. Already, the EC’s Retail Survey points to this outcome (Chart 4). Despite these inflationary developments, most economic forces indicate that the Eurozone’s core and headline CPI will not stay elevated for long. Chart 3Stronger Employment In Pandemic-Hit Sectors Chart 4Re-Opening Pricing Pressures Our Trimmed Mean Inflation measure for the Euro Area (which mimics the construction of the Cleveland Fed Trimmed-Mean CPI in the US) has weakened to 0.1% (Chart 5). Hence, underlying inflation trends are still muted and the recent uptick in core CPI reflects outliers, as has been the case in the US. The outlook for the components of CPI confirms that any uptick in Euro Area inflation will be temporary. Shelter inflation, which accounts for 24% of the ECB core CPI, will rise as the unemployment rate declines. However, the strength in the euro is limiting import prices, which will cap non-energy industrial goods inflation (Chart 6). Moreover, the peak in oil price annual increases points toward a rollover in transportation inflation. Together, these two categories represent almost 60% of the core CPI components. Chart 5Inflation Is Not Broad-Based Chart 6Key CPI Components Will Slow Labor market dynamics are also consistent with a temporary inflation spurt. Total hours worked remain 6.5% below their pre-COVID-19 summit and underneath the level congruent with full employment based on the size of the Eurozone’s working-age population (Chart 7). This model understates the slack in the labor market, because the reforms implemented in peripheral economies in the wake of last decade’s Euro Area crisis have brought down structural unemployment. Moreover, the chart shows that, after total hours worked return to their equilibrium, it still takes a few years before negotiated wages firm up. Even if labor shortages materialized earlier than we anticipate, it does not guarantee a pickup in core CPI. From 2016 to 2019, a large proportion of Euro Area businesses cited labor shortages as a key factor limiting production. Yet, despite both this perceived tightness and a trendless euro, core CPI remained flat, averaging 1% per annum (Chart 8). Chart 7Still Too Much Slack Chart 8Labor Shortages Do Not Guarantee Inflation Outside of the labor market, the amount of stimulus injections also argues against a permanent increase in European inflation. BCA’s US Bond Strategy, Global Investment Strategy, and Bank Credit Analyst services believe that the current spurt of US Inflation is temporary, despite vast monetary and fiscal stimuli. In relation to 2019 GDP, the ECB’s liquidity injections have been larger than those of the Fed; however, the US fiscal activism greatly outdid that of the Eurozone (Chart 9). Consequently, the combined monetary and fiscal impulse in the US is larger, and its greater weight toward fiscal policy makes it more inflationary. Thus, if the US is unlikely to see durable inflation, the Eurozone is even less at risk. Chart 9More Timid European Stimulus Chart 10Lower European Inflation Expectations Euro Area inflation expectations are also muted compared to that of the US (Chart 10). This development confirms that Eurozone policy is less inflationary than that of the US. It also creates an anchor for realized inflation, which will constrain the acceleration in the Euro Area CPI. Financial Conditions The ECB is deeply concerned about the impact of the hurried removal of monetary accommodation on the Eurozone’s financial conditions. Chart 11The Euro Is Deflationary The ECB does not want to see a much more rapid pace of appreciation in the euro. If it begins to slow its QE program when the Fed remains reluctant to talk about tapering, EUR/USD will surge. This will feed into weaker core inflation in the region. The ECB’s broad trade-weighted euro, based on 41 currencies, has already rallied to a record high. Thus, an even more rapid euro rally would spell deeper deflationary pressures in the region (Chart 11). Peripheral spreads remain fragile. The ECB will not want to cause a rapid widening of Italian, Spanish, or Greek government bond spreads by decreasing its asset purchases prematurely. Otherwise, the health of the banking sector in the periphery will once again deteriorate, which will both harm the recovery and ignite deflationary tendencies. Strategy Review The ECB’s Strategy Review also prevents the Governing Council from adjusting policy. The ECB will release its Strategy Review in September or October. This exercise could result in a change to the inflation target. In line with the new Fed Average Inflation Target, the ECB objective may become more symmetric. Inflation has not hit the ECB’s target of nearly 2% since 2012, and the level of HICP stands 8% below what the target implies. Therefore, if the ECB adjusts its target this fall, it will become harder to justify the removal of accommodation. Bottom Line: The ECB wants to avoid a repeat of its 2011 policy mistake, when it tightened policy prematurely and catalyzed a period of profound weakness in the European economy. Eurozone inflation will increase this year; however, this bump is transitory and inflation will once again decline in 2022. Moreover, the ECB rightfully worries about tightening financial conditions, because the euro is exerting profound deflationary forces on the continent and peripheral spreads remain fragile. Finally, the ongoing Strategy Review limits what the ECB can do until its results are known. Look Out For Q4 2021 The ECB will keep the PEPP program in place until March 2022, as was originally announced. Therefore, the ECB will only telegraph its intention after the summer and will most likely announce in December its firm commitment to begin tapering. The program size does not constrain the ECB. The total envelope of the PEPP stands at EUR1850 billion, and the ECB has already purchased EUR1100 billion (Chart 12). Based on the current accelerated pace of purchases, the ECB will run out of room in February 2022. Thus, the ECB continues to enjoy great flexibility without adjusting the PEPP program meaningfully. Chart 12Plentiful PEPP Room Chart 13China Will Act As A Drag Chart 14The Global Growth Tax Is Biding The expanding threat of a global growth scare will likely limit the ability of the ECB to tighten policy ahead of Q4. China’s credit impulse is decelerating, which portends an imminent peak in our BCA Global Industrial Activity Nowcast (Chart 13). Moreover, the rise in global yields since August 2020 and the rapid rally in oil prices since April 2020 are consistent with a meaningful deceleration in global manufacturing activity. The collapse in our Global Leading Economic Indicator Diffusion Index also hints at a coming global soft patch (Chart 14). Hence, the heightened sensitivity of the Euro Area economy to the global manufacturing sector  points toward softer-than-anticipated growth this summer. Historically, a deceleration of the Chinese PMI New Orders components warns of a decline in the 1-year forward EONIA (Chart 15). While the ECB is unlikely to flag a rate reduction in response to the upcoming global deterioration, it could respond by delaying its tapering decision. Ultimately, the accumulation of constraints and risks suggests that, even after the PEPP taper starts in 2022, the ECB will roll it into the older PSPP program. The ECB will want to keep a lid on peripheral spreads and guarantee that the euro does not melt up. Germany is unlikely to block this initiative, because its large Target 2 surplus means that problems in the periphery will percolate to the German banking system (Chart 16). Moreover, Germany’s export sector will benefit from a euro whose appreciation is contained. Chart 15Chinese New Orders Are Inconsistent With A Tighter ECB Chart 16Germany Does Not Want Italian Troubles Bottom Line: The ECB will not formally announce its tapering until December 2021. The ECB still has considerable room to continue using the PEPP program, and the global economy is likely to generate a negative growth surprise this summer. Instead, once the PEPP taper begins in 2022, the program will be rolled into the PSPP rather than being completely discarded. European policy, therefore, will remain accommodative. Investment Implications A dovish ECB is consistent with a continued overweight in European peripheral bonds. Chart 17European Peripheral Bonds Remain Attractive Portuguese, Greek, Spanish, and Italian bonds offer much more attractive valuations than the global or the European averages (Chart 17). The robust pace of ECB bond purchases, along with the increased fiscal risk-sharing created by the NGEU programs, will allow this value to continue to generate excess returns for investors. The growth scare, however, threatens our positive stance on European equities and cyclical stocks. We expect a correction to take place this summer or early fall. Thus, investors should raise cash now to buy cyclicals stocks once they correct. First, a deceleration in global growth catalyzed by a Chinese credit slowdown is consistent with an underperformance of cyclical stocks and European stocks in general. Second, the ECB Central Bank Monitor currently sports an elevated 2.1 reading, which is negative for cyclicals. A high reading for the monitor materializes when the Eurozone economy is experiencing strong momentum. However, markets are forward looking, and they rapidly internalize a brightened outlook. Once the price of cyclical stocks embed enough good news, they will start to generate poorer returns. Consequently, positive readings of the monitor are followed by negative relative excess returns for cyclical stocks, such as Industrials, Financials, Tech, and Consumer discretionary on both 6- and 12-month horizons (Table 2A). Table 2AThe Higher The ECB Monitor Rises, The More Poorly Cyclicals Perform The higher the ECB Monitor reaches, the worse the cyclical sectors’ excess returns become, even if the ECB does not tighten policy. Moreover, outliers do not distort the results of the study. The batting averages confirm that, the higher the ECB Monitor, the lower the probability of a subsequent outperformance of cyclicals. The reverse is true for defensive sectors. The higher the ECB Monitor climbs, the greater the subsequent 6- and 12-month relative excess returns for Telecommunication, Consumer Staples, Utilities, and Healthcare turn out. Their probability of outperformance also increases (Table 2B). Table 2BThe Higher The ECB Monitor Rises, The More Poorly Cyclicals Perform Investors should therefore curtail their exposure to risk over the coming months, tactically tilt toward some attractive defensive names and buy some hedges or raise some cash in order to participate more fully in the rest of the rally later this year. Bottom Line: An easy ECB policy favors an overweight stance in European peripheral bonds. However, if global growth slows, the current reading of our ECB Monitor is consistent with a period of underperformance for cyclical equities. Such underperformance should correlate with a corrective episode for the broad market as well as an underperformance of European stocks relative to the US. Investors, therefore, should raise cash levels and tactically move into attractive defensive names in order to buy back cyclicals later this year.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance   Sector Performance​​​​​​​