Currencies

Highlights The DXY index appears to be following the seasonal pattern of strengthening in the summer and weakening towards year-end. In this context, the most attractive vehicles to play a decline in the dollar are the Scandinavian currencies over the longer term, and the yen in the very near term. Our composite attractiveness model ranks the US dollar and the NZ kiwi as the least attractive currencies, particularly on the basis of valuation. Our limit buy on long AUD/NZD was triggered at 1.05. Pessimism on the Aussie is becoming overdone, while the economy could stage a coiled spring rebound once vaccination rates improve. Feature Chart I-1Was Dollar Strength Seasonal? Since July 20, the DXY index has been consolidating its gains, and appears to be following the general seasonal pattern of strengthening in the summer, and eventually weakening towards year-end (Chart I-1). With this as a backdrop, it is instructive to revisit our attractiveness ranking, and highlight which currencies might benefit most from a dollar decline. Our framework is based on three major vectors –   the macroeconomic environment, valuation, and sentiment. Our macro vector tracks relative economic strength as measured by relative PMIs and real interest rate differentials. Other factors such as a country’s basic balance and external vulnerability are also considered. In our valuation vector, we consider a swathe of models including PPP, more high-frequency indicators such as our intermediate-term timing model, as well as longer-term models based on relative productivity trends. Finally, we also consider positioning to gauge if our view is mainstream or out of consensus. Using this framework, the most attractive vehicles to play a decline in the dollar are the Scandinavian currencies over the longer term, and the yen more near term, if rates remain well behaved. Meanwhile, the US dollar and the kiwi rank as the least attractive currencies, particularly on the basis of valuation (Chart I-2). Chart I-2An Attractiveness Ranking Of Currencies Macroeconomic Environment: Real Interest Rates Chart I-3The US Sports A Very Negative Real Yield On the short tenors, the US is among those sporting  the most negative real rates (Chart I-3). But what is interesting is that we know that there is a divergence in how various central banks are treating their inflation overshoot relative to the Federal Reserve. For example, both Norway and New Zealand have negative 2-year real rates, but their central banks are on track to lift short rates this year. However, the telegraphed messages from the Fed are that there will be no interest rate increases until 2023. This will push US real rates towards becoming more negative vis-à-vis other G10 countries. In our report titled Which Rates Matter For Currencies, we suggested that the recent decline in US Treasury yields should curtail strong inflows into US fixed income. This should ease upward pressure on the dollar. Macroeconomic Environment: Basic Balance Chart I-4Basic Balances Across The G10 The basic balance is one of the most important determinants of a currency’s attractiveness, simply because it captures the ebb and flow of demand for a country’s domestic assets. In a nutshell, the basic balance is the sum of the current account surplus and long-term investments. Trade surpluses underpin underlying demand for a country’s goods and services, while capital account surpluses suggest a country’s assets are under high demand. As such, persistent basic balance surpluses are usually associated with an appreciating currency and vice versa. There has been a sea change in the basic balances across the G10, a fact we highlighted in our recent report titled On The Fed Shift, And Balance Of Payments. One of those shifts involves Australia  seeing tremendous improvement in its basic balance surplus. In terms of rankings, Sweden sports the best basic balance surplus in the G10, followed by Australia and the euro area (Chart I-4). Meanwhile, the US ranks the worst in terms of basic balances, a big vulnerability for the currency. Macroeconomic Environment: External Debt A country’s external debt situation tends to only matter during crises. Therefore, in the current context of global fiscal and monetary stimulus, as well as generous Fed swap lines to assuage any dollar funding pressures abroad, external (especially USD) debt does not pose a significant threat for currencies. In an absolute sense, external debt as a share of GDP is highest in the UK, Switzerland, and Sweden (Chart I-5). However, what matters most often for vulnerability are net external assets rather than gross liabilities. Based on this measure, Japan, Norway, Canada, Switzerland and Sweden are the most attractive countries, based on net external assets (Chart I-6). Chart I-5External Debt In The G10 Chart I-6Net International Investment In The G10 Valuation: Purchasing Power Parity (PPP) Our PPP valuation model is our default in terms of evaluating a currency’s fair value, since by definition, it reveals price arbitration between any two countries.  Chart I-7The Dollar Is Expensive As we have documented, our model offers unique insight into a true PPP fair value, since it accounts for the fact that consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, two adjustments are necessary. First, categorizing the consumer price index (CPI) into five major groups. In most cases, this breakdown captures 90% of the national CPI basket. This includes food, restaurants, and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to test the significance of individual price ratios, with the exchange rate as the dependent variable. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. As a control strategy, we use a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-country comparison, as opposed to using the national CPI weights. The results show the US dollar as overvalued, especially versus the Scandinavian currencies and the yen (Chart I-7). The results are based on the synthetic relative price ratio. Valuation: Intermediate-Term Timing Model (ITTM) Our ITTM is our favored model in the short term, because it gives signals with much higher frequency. Back in 2016, when we developed this indicator, it proved useful in helping global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed world country, there were three key variables that influenced the near-term path of its exchange rate versus the US dollar: Interest Rate Differentials: We have elaborated at length that interest rate differentials are a key driver for currencies. Given that we get interest rates in real time, they are great inputs into any high-frequency model. Inflation Differentials: Inflation destroys the purchasing power of a currency, both in theory and practice (Chart I-8).  Assuming no transactional costs, the price of a dishwasher cannot be relatively high and rising in New York versus Manila. Either the US dollar needs to fall, the Philippine peso needs to rise, or a combination of the two has to occur to equalize prices across borders. Risk Factor: Exchange rates are risk assets. Ergo, the ebb and flow of risk aversion will have an impact on currencies, which is particularly the case for commodity exporters. We will be releasing a revamped version of our trading model in the coming weeks, incorporating results from ITTM. In a nutshell, our ITTM models have been a very good timing tool. And the signal today is to overweight JPY, AUD, SEK, and NOK in the G10 space (Chart I-9). Chart I-8Inflations and Currencies Chart I-9The Dollar Is Expensive Shorter Term Valuation: Long-Term Fair Value Model Chart I-10The Dollar Is Not Attractive Longer Term Our long-term FX models try to capture the movement in exchange rates over a business cycle (3-5 years, let’s say). Included in these models are much slower-moving variables like productivity differentials, and cumulative changes in the current account and basic balance. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. We did an overhaul in these models this year, to account for rising Chinese productivity. Similar to our ITTM models, the longer-term valuation indicator favors the Scandinavian currencies, the yen, and the Aussie dollar (Chart I-10). Sentiment: Speculative Positioning The final consideration in our ranking is sentiment. In general, the dollar is a momentum currency and as such, you want to be long when bullish consensus and/or net speculative positioning is low and rising. Chart I-11 shows that the dollar has failed to break above its major trendlines, at the same time when bullish consensus on the dollar is rising (Chart I-12). This warns that a powerful countertrend reversal could be underway. Chart I-11The Dollar And Momentum Chart I-12The Dollar And Sentiment   According to CFTC data, the most shorted currencies are the Australian dollar and Japanese yen (Chart I-13). In our framework, these are the currencies slated to stage very powerful countertrend reversals, given we put the pandemic behind us. Chart I-13Everyone Is Long The Greenback Housekeeping Chart I-14AUD/NZD and Relative Rates Our long AUD/NZD position was triggered this week at 1.05. The messaging from the RBA and the RBNZ have been vastly different, whereby the former is cautious about the rising Delta variant infection rate, and the latter is focused on financial stability admist a bubbly housing market. On a relative policy basis, our bias is that the likelihood of rates adjusting higher than market expectations is higher in Australia than in New Zealand (Chart I-14). As we are  eventually going to put the virus behind us, underappreciated currencies such as the AUD could stage a mean-reversion rally.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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

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

Special Report

Dear Client, This week, in lieu of our regular report, I am sending you a special report written by my colleague Jonathan LaBerge, chief strategist of our flagship The Bank Credit Analyst service. Jonathan argues that investors should see social media as a technological innovation that harms productivity. While Jonathan concedes that social media was not the main driver of policy uncertainty and political risk over the past decade, he makes a good case that it plays an aggravating role. He warns that social media and political polarization still pose risks to the macroeconomic outlook in the coming years, while also highlighting idiosyncratic risks threatening social media stocks. We trust that you will find this report insightful. We will resume regular publication next week. All very best, Matt Gertken   Vice President Geopolitical Strategy US Political Strategy BCA Research Highlights Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. The cyclical component of productivity was long lasting in nature during the last economic expansion. Forces that negatively impact economic growth but do not change the factors of production necessarily reduce measured productivity, and repeated policy mistakes strongly contributed to the slow growth profile of the last economic cycle. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. The risks of additional mistakes from populism remain present, even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation. A potential revival in protectionist sentiment is a risk to a constructive cyclical view that we will be closely monitoring over the coming 12-24 months. Investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing these companies from the public’s impression of the impact of social media on society – especially if social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case). Feature Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. While the risk of premature fiscal consolidation appears low today compared to the 2010-14 period, the pandemic and its aftermath could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year in the lead up to the 2022 mid-term elections. The midterms, for their part, are expected to bring gridlock back into US politics, which could remove fiscal options should the economy backslide. Frequent shocks during the last economic expansion reinforced the narrative of secular stagnation. In the coming years, any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates – despite the case for cyclically and structurally higher bond yields. In addition, investors with concentrated positions in social media companies should take seriously the long-term idiosyncratic risks facing these stocks. These risks stem from the public’s impression of the impact of social media on society, particularly if social media comes to be widely associated with political gridlock, the polarization of society, and failed economic policies. A Brief History Of Social Media The earliest social networking websites date back to the late 1990s, but the most influential social media platforms, such as Facebook and Twitter, originated in the mid-2000s. Prior to the advent of modern-day smartphones, user access to platforms such as Facebook and Twitter was limited to the websites of these platforms (desktop access). Following the release of the first iPhone in June 2007, however, mobile social media applications became available, allowing users much more convenient access to these platforms. Charts 1 and 2 highlight the impact that smartphones have had on the spread of social media, especially since the release of the iPhone 3G in 2008. In 2006, Facebook had roughly 12 million monthly active users; by 2009, this number had climbed to 360 million, growing to over 600 million the year after. Twitter, by contrast, grew somewhat later, reaching 100 million monthly active users in Q3 2011. Social media usage is more common among those who are younger, but Chart 3 highlights that usage has risen over time for all age groups. As of Q1 2021, 81% of Americans aged 30-49 reported using at least one social media website, compared to 73% of those aged 50-64 and 45% of those aged 65 and over. Chart 4 highlights that the usage of Twitter skews in particular toward the young, and that, by contrast, Facebook and YouTube are the social media platforms of choice among older Americans. Chart 1Facebook: Monthly Active UsersChart 2Twitter: Monthly Active Users Worldwide Chart 3A Sizeable Majority Of US Adults Regularly Use Social Media Chart 4Older Americans Use Facebook Far More Than Twitter As a final point documenting the development and significance of social media, Chart 5 highlights that more Americans now report consuming news often (roughly once per day) from a smartphone, computer, or tablet other than from television. Radio and print have been completely eclipsed as sources of frequent news. The major news publications themselves are often promoted through social media, but the rise of the Internet has weighed heavily on the journalism industry. Social media has, for better and for worse, enabled the rapid proliferation of alternative news, citizen journalism, rumor, conspiracy theories, and foreign disinformation. Chart 5Social Media Has Changed The Way People Consume News The Link Between Social Media And Post-GFC Austerity Following the 2008-2009 global financial crisis (GFC), there have been at least five deeply impactful non-monetary shocks to the US and global economies that have contributed to the disconnection between growth and interest rates: A prolonged period of US household deleveraging from 2008-2014 The Euro Area sovereign debt crisis Fiscal austerity in the US, UK, and Euro Area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The rise of populist economic policies, such as the UK decision to leave the European Union, and the US-initiated trade war of 2018-2019. Among these shocks to growth, social media has had a clear impact on two of them. In the case of austerity in the aftermath of the Great Recession, a sharp rise in fiscal conservatism in 2009 and 2010, emblematized by the rise of the US Tea Party, profoundly affected the 2010 US midterm elections. It is not surprising that there was a fiscally conservative backlash following the crisis: the US budget deficit and debt-to-GDP ratio soared after the economy collapsed and the government enacted fiscal stimulus to bail out the banking system. And midterm elections in the US often lead to significant gains for the opposition party However, Tea Party supporters rapidly took up a new means of communicating to mobilize politically, and there is evidence that this contributed to their electoral success. Chart 6 illustrates that the number of tweets with the Tea Party hashtag rose significantly in 2010 in the lead-up to the election, which saw the Republican Party take control of the House of Representatives as well as the victory of several Tea Party-endorsed politicians. Table 1 highlights that Tea Party candidates, who rode the wave of fiscal conservatism, significantly outperformed Democrats and non-Tea Party Republicans in the use of Twitter during the 2010 campaign, underscoring that social media use was a factor aiding outreach to voters. Chart 6Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Table 1Tea Party Candidates Significantly Outperformed In Their Use Of Social Media And while it is more difficult to analyze the use and impact of Facebook by Tea Party candidates and supporters owing to inherent differences in the structure of the Facebook platform, interviews with core organizers of both the Tea Party and Occupy Wall Street movements have noted that activists in these ideologically opposed groups viewed Facebook as the most important social networking service for their political activities.1 Under normal circumstances, we agree that fiscal policy should be symmetric, with reduced fiscal support during economic expansions following fiscal easing during recessions. But in the context of multi-year household deleveraging, the fiscal drag that occurred in following the 2010 midterm elections was clearly a policy mistake. This mistake occurred partially under full Democratic control of government and especially under a gridlocked Congress after 2010. Chart 7 highlights that the contribution to growth from government spending turned sharpy negative in 2010 and continued to subtract from growth for some time thereafter. In addition, panel of Chart 7 highlights that the US economic policy uncertainty index rose in 2010 after falling during the first year of the recovery, reaching a new high in 2011 during the Tea Party-inspired debt ceiling crisis. Chart 7The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake In addition to the negative impact of government spending on economic growth, this extreme uncertainty very likely damaged confidence in the economic recovery, contributing to the subpar pace of growth in the first half of the last economic expansion. Chart 8 highlights the weak evolution in real per capita GDP from 2009-2019 compared with previous economic cycles, which was caused by a prolonged household balance sheet recovery process that was made worse by policy mistakes. To be sure, the UK and the EU did not have a Tea Party, and yet political elites imposed fiscal austerity. It is also the case that President Obama was the first president to embrace social media as a political and public relations tool. So it cannot be said that either social media or the Republican Party are uniquely to blame for the policy mistakes of that era. But US fiscal policy would have been considerably looser in the 2010s if not for the Tea Party backlash, which was partly enabled by social media. Too tight of fiscal policy in turn fed populism and produced additional policy mistakes down the road. Chart 8Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile From Fiscal Drag To Populism While social media is clearly not the root cause of the recent rise of populist policies, it has had a hand in bringing them about – in both a direct and indirect manner. The indirect link between social media use and the rise in populist policies has mainly occurred through the highly successful use of social media by international terrorist organizations (chiefly ISIL) and its impact on sentiment toward immigration in several developed market economies. Chart 9 highlights that public concerns about immigration and race in the UK began to rise sharply in 2012, in lockstep with both the rise in UK immigrants from EU accession countries and a series of events: the Syrian refugee crisis, the establishment and reign of the Islamic State, and three major terrorist attacks in European countries for which ISIL claimed responsibility. Given that the main argument for “Brexit” was for the UK to regain control over its immigration policies, these events almost certainly increased UK public support for withdrawing from the EU. In other words, it is not clear that Brexit would have occurred (at least at that moment in time) without these events given the narrow margin of victory for the “leave” campaign. The absence of social media would not have prevented the rise of ISIL, as that occurred in response to the US’s precipitous withdrawal from Iraq. The inevitable rise of ISIL would still have generated a backlash against immigration. Moreover, fiscal austerity in the UK and EU also fed other grievances that supported the Brexit movement. But social media accelerated and amplified the entire process.  Chart 10 presents fairly strong evidence that Brexit weakened UK economic performance relative to the Euro Area prior to the pandemic, with the exception of the 2018-2019 period. In this period Euro Area manufacturing underperformed during the Trump administration’s trade war as a result of its comparatively higher exposure to automobile production and its stronger ties to China. Panel 2 highlights that GBP-EUR fell sharply in advance of the referendum, and remains comparatively weak today. Chart 9Terrorism And Immigration Likely Contributed To Brexit Chart 10Brexit Weakened UK Economic Performance Prior To The Pandemic Turning to the US, Donald Trump’s election as US President in 2016 was aided by both the direct and indirect effects of social media. In terms of indirect effects, Trump benefited from similar concerns over immigration and terrorism that caused the UK to leave the EU: Chart 11 highlights that terrorism and foreign policy were second and third on the list of concerns of registered voters in mid-2016, and Chart 12 highlights that voters regarded Trump as the better candidate to defend the US against future terrorist attacks. Chart 11Terrorism Ranked Highly As An Issue In The 2016 US Election Chart 12Voters Regarded Trump As Better Equipped To Defend Against Terrorism Trump’s election; and the enactment of populist policies under his administration, were directly aided by Trump’s active use of social media (mainly Twitter) to boost his candidacy. Chart 13 highlights that there were an average of 15-20 tweets per day from Trump’s Twitter account from 2013-2015, and 80% of those tweets occurred before he announced his candidacy for president in June 2015. This strongly underscores that Trump mainly used Twitter to lay the groundwork for his candidacy as an unconventional political outsider rather than as a campaign tool itself, which distinguishes his use of social media from that of other politicians. In other words, new technology disrupted the “good old boys’ club” of traditional media and elite politics. Chart 13Trump Used Twitter To Lay The Groundwork For His Candidacy Chart 14The Trump Tax Cuts A Huge Rise In Corporate Earnings Some policies of the Trump administration were positive for financial markets, and it is fair to say that Trump fired up animal spirits to some extent: Chart 14 highlights that the Tax Cuts and Jobs Act caused a significant rise in stock market earnings per share. But the Trump tax cuts were a conventional policy pushed mostly by the Congressional leadership of the Republican Party, and they did not meaningfully boost economic growth. Chart 15 highlights that, while the US ISM manufacturing index rose sharply in the first year of Trump’s administration, an uptrend was already underway prior to the election as a result of a significant improvement in Chinese credit growth and a recovery in oil prices after the devastating collapse that took place in 2014-2015. Chart 15But The Tax Cuts Did Not Do Much To Boost Growth Similarly, Chart 15 highlights that the Trump trade war does not bear the full responsibility of the significant slowdown in growth in 2019, as China’s credit impulse decelerated significantly between the passage of the Tax Cuts and Jobs Act and the onset of the trade war because Chinese policymakers turned to address domestic concerns. But Chart 16 highlights that the aggressive imposition of tariffs, especially between the US and China, caused an explosion in trade uncertainty even when measured on an equally-weighted basis (i.e., when overweighting trade uncertainty, in countries other than the US and China), which undoubtedly weighed on the global economy and contributed to a very significant slowdown in US jobs growth in 2019 (panel 2). Moreover, Chinese policymakers responded to the trade onslaught by deleveraging, which weighed on the global economy; and consolidating their grip on power at home. In essence, Trump was a political outsider who utilized social media to bypass the traditional media and make his case to the American people. Other factors contributed to his surprising victory, not the least of which was the austerity-induced, slow-growth recovery in key swing states. While US policy was already shifting to be more confrontational toward China, the Trump administration was more belligerent in its use of tariffs than previous administrations. The trade war thus qualifies as another policy shock that was facilitated by the existence of social media. Chart 16The Trade War Caused An Explosion In Global Trade Uncertainty Viewing Social Media As A Negative Productivity-Innovation A rise in fiscal conservatism leading to misguided austerity, the UK’s decision to leave the European Union, and the Trump administration’s trade war have represented significant non-monetary shocks to both the US and global economies over the past 12 years. These shocks strongly contributed to the subpar growth profile of the last economic expansion, as demonstrated above. Given the above, it is reasonable for investors to view social media as a technological innovation with negative productivity growth, given that it has facilitated policy mistakes during the last economic expansion. Chart 17 underscores this point, by highlighting that multi-factor productivity growth has been extremely weak in the post-GFC environment. While productivity is usually driven by supply-side factors over the longer term, it has a cyclical component to it – and in the case of the last economic expansion, the cyclical component was long lasting in nature. Any forces negatively impacting economic growth that do not change the factors of production necessarily reduce measured productivity; it is for this reason that measured productivity declines during recessions; and policy mistakes negatively impact productivity growth. Chart 17Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Chart 18State & Local Government Finances Are In Much Better Shape Today The Risk Of Aggressive Austerity Seems Low Today… Fiscal austerity in the early phase of the last economic cycle was the first social media-linked shock that we identified, but the risk of aggressive austerity appears low today. Much of the fiscal drag that occurred in the aftermath of the global financial crisis happened because of insufficient financial support to state and local governments – and the subsequent refusal by Congress to authorize more aid. But Chart 18 highlights that state and local government finances have already meaningfully recovered, on the back of bipartisan stimulus in 2020, while the American Rescue Plan provides significant additional funding. While it is true that US fiscal policy is set to detract from growth over the coming 6-12 months, this will merely reflect the unwinding of fiscal aid that had aimed to support household income temporarily lost, as a result of a drastic reduction in services spending. As we noted in last month’s report,2 goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the deployment of some of the sizable excess savings that US households have accumulated over the past year. Fiscal drag will also occur outside of the US next year. For example, the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, which would represent the largest annual increase over the past two decades. But here too the reduction in government spending will reflect the end of pandemic-related income support, and is likely to occur alongside a positive private-sector services impulse. During the worst of the Euro Area sovereign debt crisis, the impact of austerity was especially acute because it was persistent, and it occurred while the output gap was still large in several Euro Area economies. Chart 19 highlights that Euro Area fiscal consolidation from 2010-2013 was negatively correlated with economic activity during that period, and Chart 20 highlights that, with the potential exception of Spain, this austerity does not appear to have led to subsequently stronger rates of growth. Chart 19Euro Area Austerity Lowered Growth During The Consolidation Phase… Chart 20…And Did Not Seem To Subsequently Raise Growth This experiment in austerity led the IMF to conclude that fiscal multipliers are indeed large during periods of substantial economic slack, constrained monetary policy, and synchronized fiscal adjustment across numerous economies.3 Similarly, attitudes about austerity have shifted among policymakers globally in the wake of the populist backlash. Given this, despite the significant increase in government debt levels that has occurred as a result of the pandemic, we strongly doubt that advanced economies will attempt to engage in additional austerity prematurely, i.e., before unemployment rates have returned close-to steady-state levels. …But The Risk Of Protectionism And Other Populist Measures Looms Large The role that social media has played at magnifying populist policies should be concerning for investors, especially given that there has been a rising trend towards populism over the past 20 years. In a recent paper, Funke, Schularick, and Trebesch have compiled a cross-country database on populism dating back to 1900, defining populist leaders as those who employ a political strategy focusing on the conflict between “the people” and “the elites.” Chart 21 highlights that the number of populist governments worldwide has risen significantly since the 1980s and 1990s, and Chart 22 highlights that the economic performance of countries with populist leaders is clearly negative. Chart 21Populism Has Been On The Rise For The Past 30 Years The authors found that countries’ real GDP growth underperformed by approximately one percentage point per year after a populist leader comes to power, relative to both the country’s own long-term growth rate and relative to the prevailing level of global growth. To control for the potential causal link between economic growth and the rise of populist leaders, Chart 23 highlights the results of a synthetic control method employed by the authors that generates a similar conclusion to the unconditional averages shown in Chart 22: populist economic policies are significantly negative for real economic growth. Chart 22Populist Leaders Are Clearly Growth Killers Even After… Chart 23… Controlling For The Odds That Weak Growth Leads To Populism This is especially concerning given that wealth and income inequality, perhaps the single most important structural cause of rising populism and political polarization, is nearly as elevated as it was in the 1920s and 1930s (Chart 24). This trend, at least in the US, has been exacerbated by a decline in public trust of mainstream media among independents and Republicans that began in the early 2000s and helped to fuel the public’s adoption of alternative news and social media. The decline in trust clearly accelerated as a result of erroneous reporting on what turned out to be nonexistent weapons of mass destruction in Iraq and other controversies of the Bush administration. Chart 21 showed that the rise in populism has also yet to abate, suggesting that social media has the potential to continue to amplify policy mistakes for the foreseeable future. Chart 24Inequality: The Most Important Structural Cause Of Populism And Polarization It is not yet clear what economic mistakes will occur under the Biden administration, but investors should not rule out the possibility of policies that are harmful for growth. The likely passage of a bipartisan infrastructure bill or a partisan reconciliation bill in the second half of this year will most likely be the final word on fiscal policy until at least 2025,4 underscoring that active fiscal austerity is not likely a major risk to investors. Spending levels will probably freeze after 2022: Republicans will not be able to slash spending, and Democrats will not be able to hike spending or taxes, if Republicans win at least one chamber of Congress in the midterms (as is likely). Biden has preserved the most significant of Trump’s protectionist policies by maintaining US import tariffs against China, and the lesson from the Tea Party’s surge following the global financial crisis is that major political shifts, magnified by social media, can manifest themselves as policy with the potential to impact economic activity within a two-year window. Attitudes toward China have shifted negatively around the world because of deindustrialization and now the pandemic.5 White collar workers in DM countries have clearly fared better during lockdowns than those of lower-income households. This has created extremely fertile ground for a revival in populist sentiment, which could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year, in the lead up to the 2022 mid-term elections. Investment Conclusions In this report, we have documented the historical link between social media, populism, and policy mistakes during the last economic expansion. It is clear that neither social media nor even populism is solely responsible for all mistakes – the UK’s and EU’s ill-judged foray into austerity was driven by elites. Furthermore, we have not addressed in this report the impact of populism on actions of emerging markets, such as China and Russia, whose own behavior has dealt disinflationary blows to the global economy. Nevertheless, populism is a potent force that clearly has the power to harness new technology and deliver shocks to the global economy and financial markets. The risks of additional mistakes from populism are still present, and that is even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation – contributing to the vaccine hesitancy in some DM countries that we discussed in Section 1 of our report. Two investment conclusions emerge from our analysis. First, we noted in our April report that there is a chance that investor expectations for the natural rate of interest (“R-star”) will rise once the economy normalizes post-pandemic, but that this will likely not occur as long as investors continue to believe in the narrative of secular stagnation. Despite the fact that the past decade’s shocks occurred against the backdrop of persistent household deleveraging (which has ended in the US), these shocks reinforced that narrative, and any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates. Thus, while the rapid closure of output gaps in advanced economies over the coming year argues for both cyclically and structurally higher bond yields, a revival in protectionist sentiment is a risk to this view that we will be closely monitoring over the coming 12-24 months. Second, for tech investors, the bipartisan shift in public sentiment to become more critical of social media companies is gradually becoming a real risk, potentially affecting user growth. Based solely on Facebook, Twitter, Pinterest, and Snapchat, social media companies do not account for a very significant share of the overall equity market (Chart 25), suggesting that the impact of a negative shift in sentiment toward social media companies would not be an overly significant event for equity investors in general. Chart 25 highlights that the share of social media companies as a percent of the broad tech sector rises if Google is included; YouTube accounts for less than 15% of Google’s total advertising revenue, however, suggesting modest additional exposure beyond the solid line in Chart 25. Chart 25The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market Still, investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing social media companies as a result of the public’s impression of the impact of social media on society. If social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case), then the fundamental performance of these stocks is likely to be quite poor regardless of whether or not tech companies ultimately enjoy a relatively friendly regulatory environment under the Biden administration.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     Grassroots Organizing in the Digital Age: Considering Values and Technology in Tea Party and Occupy Wall Street by Agarwal, Barthel, Rost, Borning, Bennett, and Johnson, Information, Communication & Society, 2014. 2     Please see The Bank Credit Analyst “July 2021,” dated June 24, 2021, available at bca.bcaresearch.com 3    “Are We Underestimating Short-Term Fiscal Multipliers?”,IMF World Economic Outlook, October 2012 4    Please see US Political Strategy Outlook "Third Quarter Outlook 2021: Game Time," dated June 30, 2021, available at usps.bcaresearch.com 5    “Unfavorable Views of China Reach Historic Highs in Many Countries,” PEW Research Center, October 2020.