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Highlights The Greens are likely to win control of Germany’s government in the September 26 federal elections. At least they will be very influential in the new coalition. Germany has achieved may of its long-term geopolitical goals within the EU. There is consensus on dovish monetary and fiscal policy and hawkish environmental policy. The biggest changes will come from the outside. The US and Germany have a more difficult relationship. While they both oppose Russian and Chinese aggression, Germany will resist American aggression. The Christian Democrats have a 65% chance of remaining in government which would limit the Greens’ controversial and ambitious tax agenda. The 35% chance of a left-wing coalition will frontload fiscal stimulus for the sake of recovery. The economy is looking up and a Green-led fiscal easing would supercharge the recovery. However, coalition politics will likely fail to address Germany’s poor demography, deteriorating productivity, and large excess savings. On a cyclical basis, overweight peripheral European bonds relative to bunds; EUR/USD; and Italian and Spanish stocks relative to German stocks. Feature Chart 1Germans Turn To A Young Woman And A Green Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Germany is set to become the first major country to be led by a green party. At very least the German election on September 26 will see an upset in which the ruling party under-performs and the Greens over-perform (Chart 1). At 30%, online betting markets are underrating the odds that Annalena Baerbock will become the first Green chancellor in 2022 – and the first elected chancellor to hail from a third party (Chart 2). The “German question” – the problem of how to unify Germany yet keep peace with the neighbors – lay at the heart of Europe for the past two centuries but today it appears substantially resolved: a peaceful and unified Germany stands at the center of a peaceful and mostly unified Europe. There are a range of risks on the horizon but this positive backdrop should be acknowledged. Chart 2Market Waking Up To Baerbock’s Bid For Chancellorship Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green All of the likeliest scenarios for the German election will reinforce the current situation by perpetuating policies that aim for Euro Area solidarity. Even the green shift is already well underway, though a Green-led government would supercharge it. Nevertheless this year’s election is important because it heralds a leftward shift in Germany and will shape fiscal, energy, industrial, and trade policy for at least the coming four years. A left-wing sweep would generate equity market excitement in the short run – a positive fiscal surprise to supercharge the post-pandemic rebound – but over the long run it would bring greater policy uncertainty because it would cause a break with the past and possibly a structural economic shift (Chart 3). The Greens are in favor of substantial increases in taxation and regulation as well as big changes in industrial and energy policy. In the absence of a left-wing sweep, coalition politics will be a muddle and Germany’s existing policies will continue. Chart 3German Policy Uncertainty On The Rise German Policy Uncertainty On The Rise German Policy Uncertainty On The Rise Regardless of what happens within Germany, the geopolitical environment is increasingly dangerous. Germany will try to avoid getting drawn into the US’s great power struggles with Russia and China but it may not have a choice. Germany’s Geopolitics The difficulty of German unification stands at the center of modern European history. Because of the large and productive German-speaking population, unification in 1871 posed a security threat to the neighbors, culminating in the world wars. The peaceful German reunification after the Cold War created the potential for the EU to succeed and establish peace and prosperity on the continent. This arrangement has survived recent challenges. Germany’s relationship with the EU came under threat from the financial crisis, the Arab Spring and immigration influx, Brexit, and President Trump’s trade tariffs. But in the end these events cemented the reality that German and Europe are strengthening their bonds in the face of foreign pressures. Germany achieved what it had long sought – preeminence on the continent – by eschewing a military role, sticking to France economically, and avoiding conflict with Russia. Since Germany has achieved many of its long-sought strategic objectives it has not fallen victim to a nationalist backlash over the past ten years like the US and United Kingdom. However, Germany is not immune to populism or anti-establishment sentiment. The two main political blocs, the Christian Democrats and the Democratic Socialists, have suffered a loss of popular support in recent elections, forcing them into a grand coalition together. Anti-establishment feeling in Germany has moved the electorate to the left, in favor of the Greens. The Greens have risen inexorably over the past decade and have now seized the momentum only five months before an election (Chart 4). Yet the Greens in Germany are basically an establishment political party. They participate in 11 out of 16 state governments and currently hold the top position in Baden-Württemberg, Germany’s third most populous and productive state. From 1998-2005 they participated in government, getting their hands dirty with neoliberal structural reforms and overseas military deployments. Moreover the Greens cannot rule alone but will have to rule within a coalition, which will mediate their more controversial policies. Chart 4Greens Surge, Christian Democrats Falter Greens Surge, Christian Democrats Falter Greens Surge, Christian Democrats Falter Today Germany is in lock step with France and the EU by meeting three key conditions: full monetary accommodation (the German constitutional court’s challenges to the European Central Bank are ineffectual), full fiscal accommodation (Chancellor Angela Merkel agreed to joint debt issuance and loose deficit controls amid the COVID-19 crisis as well as robust green energy policies), and full security accommodation (German rearmament exists within the context of NATO and European security aspirations are undertaken in lock-step with the French). These conditions will not change in the 2021 election even assuming that the Greens take power at the head of a left-wing coalition. Bottom Line: Germany has virtually achieved its grand strategic aims of unifying and ruling Europe. No German government will challenge this situation and every German government will strive to solidify it. The greatest risks to this setup stem from abroad rather than at home. The Return Of The German Question? Germany’s geopolitical position can be summarized by Chart 5, which shows popular views toward different countries and institutions. The Germans look positively upon the EU and global institutions like the United Nations and less so NATO. They look unfavorably upon everything else. They take an unfavorable view toward Russia, but not dramatically so, which shows their lack of interest in conflict with Russia – they do not want to be the battleground or the ramparts of another major European war. They dislike the United States and China even more, and equally. Even if attitudes toward the US have improved since the 2020 election the net unfavorability is telling. Chart 5Germany More Favorable Toward Russia Than US? Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Since the global financial crisis, and especially Russia’s invasion of Ukraine in 2014, Germany has built up its military. This buildup is taking place under the prodding of the United States and in step with NATO allies, who are reacting to Russia’s military action to restore its sphere of influence in the former Soviet space (Chart 6). Germany’s military spending still falls short of NATO’s 2% of GDP target, however. It will not be seen as a threat to its neighbors as long as it remains integrated with France and Europe and geared toward deterring Russia. Chart 6Germany And NATO Increase Military Spending Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Chart 7Watch Russo-German Relations For Cracks In Europe’s Edifice Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Russia’s aggressiveness should continue to drive the Germans and Europeans into each other’s arms. This could change if Putin pursues diplomacy over military coercion, for then he could split Germany from eastern Europe. The possibility is clear from Russia’s and Germany’s current insistence on completing the Nord Stream 2 pipeline despite American and eastern European objections. The pipeline is set to be completed by September, right in time for the elections – in no small part because the Greens oppose it. If the US insists on halting the pipeline then a crisis will erupt with Russia that will humiliate Merkel and the Christian Democrats. But the US may refrain from doing so in the face of Russian military threats (odds are 50/50). The Russian positioning over 100,000 troops on the border with Ukraine this year – and now reportedly ordering them to return to base by May 1 – amounts to a test of Russo-German relations. Putin can easily expand the Russian footprint in Ukraine and tensions will remain elevated at least through the Russian legislative elections in September. Germans would respond to another invasion with sanctions, albeit likely watering down tougher sanctions proposed by the Americans. What would truly change the game would be a Russian conquest of all of Ukraine. This is unlikely – precisely because it would unite Germany, the Europeans, and the Americans solidly against Russia, to its economic loss as well as strategic disadvantage (Chart 7). China’s rise should also keep Germany bound up with Europe. The Germans fear China’s technological and manufacturing advancement, including Chinese involvement in digital infrastructure and networks. The Greens are critical of the way that carbon-heavy Chinese goods undercut the prices of carbon-lite German goods. Baerbock favors carbon adjustment fees, a pretty word for tariffs. However, the Germans want to maintain business with China and are not very afraid of China’s military. Hence there is a risk of a US-German split over the question of China. If Germany should consistently side with Russia and China over US objections then it risks attracting hostile attention from the US as well as from fellow Europeans, who will eventually fear that German power is becoming exorbitant by forming relations with giants outside the EU. But this is not the leading risk today. The US is courting Germany and seeking to renew the trans-Atlantic alliance. Meanwhile Germany needs US support against Russia’s military and China’s trade practices. US-German relations will improve unless the US forces Germany into an outright conflict with the autocratic powers. Bottom Line: The US and Germany have a more difficult relationship now than in the past but they share an interest in deterring Russian aggression and Chinese technological and trade ambitions. Biden’s attempt to confront these powers multilaterally is limited by Germany’s risk-aversion. Scenarios For The 2021 Election There are several realistic scenarios for the German election outcome. Our expectation that the Greens will form a government stems from a series of fundamental factors. Opinion polling has now clearly shifted in favor of our view, with the Greens gaining the momentum with only five months to go. Grouping the political parties into ideological blocs shows that the race is a dead heat. Our bet is that momentum will break in favor of the opposition Greens, which we explain below. Meanwhile the Free Democrats should perform well, stealing votes from the Christian Democrats. The right-wing Alternative für Deutschland (AfD), while not performing well, is persistent enough to poach some votes from the Christian Democrats. These are “lost” votes to the conservatives as none of the parties will join it in a coalition (Chart 8). Chart 8Germany's Median Voters Shifts To the Left Germany's Median Voters Shifts To the Left Germany's Median Voters Shifts To the Left The Christian Democrats bear all the signs of a stale and vulnerable government. They have been in power for 16 years and their performance in state and federal elections has eroded recently, including this year (Table 1). The public is susceptible to the powerful idea that it is time for a change. Chancellor Merkel’s approval rating is still around 60%, but in freefall, and her successful legacy is not enough to save her party, which is showing all the signs of panic: succession issues, indecision, infighting, corruption scandals. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated (Table 2).1 Table 1AChristian Democrats Fall, Greens Rise, In Recent State Elections Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Table 1BChristian Democrats Fall, Greens Rise, In Recent State Elections Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Table 2Policy Platforms Of The Green Party Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green The fact that Christian Democrats and their Bavarian sister party, the Christian Social Union, saw such a tough race for chancellor candidate is an ill omen. Moreover the party’s elites went for the safe choice of Merkel’s handpicked successor, Armin Laschet, over the more popular Markus Soeder (Chart 9), in a division that will likely haunt the party later this year. Chart 9Christian Democrats And Christian Social Union Divided Ahead Of Election Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Laschet has received a bounce in polls with the nomination but it will be temporary. He has not cut a major figure in any polling prior to now. Chart 10Dissatisfaction Points To Government Change Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green He has quarreled openly with Merkel and the coalition over pandemic management. He was not her first choice of successor anyway – that was Annagret Kramp-Karrenbauer, who fell from grace due to controversy over the faintest hint of cooperation with the AfD. There is a manifest problem filling Merkel’s shoes. Even more important than coalition infighting is the fact that Germany, like the rest of the world, has suffered a historic shock to its economy and society. The pandemic and recession were then aggravated by a botched vaccine rollout. General dissatisfaction is high, another negative sign for the incumbent party (Chart 10). Of course, the election is still five months away. The vaccine will make its way around, the economy will reopen, and consumers will look up – see below for the very positive macro upturn that Germany should expect between now and the election. Voters have largely favored strict pandemic measures and Merkel will have long coattails. This Christian Democrats and Christian Social Union have ruled modern Germany for all but 15 years and have not fallen beneath 33% of the popular vote since reunification. The Greens have frequently aroused more energy in opinion polling than at the voting booth. With these points in mind, we offer the following election scenarios with our subjective probabilities: Green-Red-Red Coalition – Greens rule without Christian Democrats – 35% odds. Green-Black Coalition – Greens rule with Christian Democrats – 30% odds. Black-Green Coalition – Christian Democrats rule with Greens – 25% odds. Grand Coalition (Status Quo) – Christian Democrats rule without Greens – 10% odds. Our subjective probabilities are based on the opinion polls and online betting cited above but adjusted for the Greens’ momentum, the Christian Democrats’ internal divisions, the “time for change” factor, and the presence of a historic exogenous economic and social shock. Geopolitical surprises could occur before the election but they would most likely reinforce the Greens, since they have taken a hawkish line against Russia and China. Bottom Line: The Greens are likely to lead the next German government but at very least they will have a powerful influence. Policy Impacts Of Election Scenarios The makeup of the ruling coalition will determine the parameters of new policy. Fiscal policy will change based on the election outcome – both spending and taxes. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated.2 The Greens’ idea is to “steer” the rebuilding process through environmental policy. But if the left lacks a strong majority then the Greens’ more controversial and punitive measures will not get through. Transformative policies will weigh heavily on the lower classes (Chart 11). Chart 11Ambitious Climate Policy Will Face Resistance Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green The policy dispositions of the various chancellor candidates help to illustrate Germany’s high degree of policy consensus. Table 3 looks at the candidates based on whether they are “hawkish” (active or offensive) or “dovish” (passive or defensive) on a given policy area. What stands out is the agreement among the different candidates despite party differences. Nobody is a fiscal or monetary hawk. Only Baerbock can be classified as a hawk on trade.3 Nobody is a hawk on immigration. Nearly everyone is a hawk on fighting climate change. And attitudes are turning more skeptical of Russia and China, though not outright hawkish. Table 3Policy Consensus Among German Chancellor Candidates Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Germany will not abandon its green initiatives even if the Greens underperform. The current grand coalition pursued a climate package due to popular pressure even with the Greens in opposition. Germans are considerably more pro-environment even than other Europeans (Chart 12). The green shift is also happening across the world. The US is now joining the green race while China is doubling down for its own reasons. See the Appendix for current green targets and measures, which have been updated in the wake of a slew of announcements before Biden’s Earth Day climate summit on April 22-23. Chart 12Germans Care Even More About Environment Than Other Europeans Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Any coalition will raise spending more than taxes since it will be focused on post-COVID economic recovery. There has been a long prelude to Germany’s proactive fiscal shift – it has staying power and is not to be dismissed. A Christian Democratic coalition would try to restore fiscal discipline sooner than otherwise but there is only a 5% chance that it will have the power to do so according to the scenarios given above. The rest of Europe will be motivated to spend aggressively while EU fiscal caps are on hold in 2022, especially if the German government is taking a more dovish turn. Even more than the US and UK, Germany is turning away from the neoliberal Washington Consensus. But Germans are not experiencing any kind of US-style surge of polarization and populism. At least not yet. It may be a risk over the long run, depending on the fate of the Christian Democrats, the AfD, and various internal and external developments. Bottom Line: Germany has a national consensus that consists of dovish monetary, fiscal, trade, and immigration policies and hawkish (pro-green) environmental policy. Germany is turning less dovish on geopolitical conflicts with Russia and China. Given that a coalition government is likely, this consensus is likely to determine actual policy in the wake of this year’s election. A few things are clear regardless of the ruling coalition. First, Germany is seeking domestic demand as a new source of growth, to rebalance its economy and deepen EU integration. Second, Germany is accelerating its green energy drive. Third, Germany cannot accept being in the middle of a new cold war with Russia. Fourth, Germany has an ambivalent policy on China. Germany’s Macro Outlook Even before considering the broader fiscal picture, the outlook for German economic activity over the course of the coming 12 to 24 months was already positive. Our base case scenario for the September election, which foresees a coalition government led by the Green Party, only confirms this optimistic view. However, Germany is still facing significant long-term challenges, and, so far, there has not been a political consensus to address these structural headwinds adequately. The Greens offer some solutions but not all of their proposals are constructive and much will depend on their parliamentary strength. Peering Into The Near-Term… Germany’s economy is set to benefit from the continued recovery of the global business cycle, which is a view at the core of BCA Research’s current outlook.4 Germany remains a trading and manufacturing powerhouse, and thus, it will reap a significant dividend from the continued global manufacturing upswing. Manufacturing and trade amount to 20% and 88% of Germany’s GDP, the highest percentage of any major economy. Alternatively, according to the OECD, foreign demand for German goods accounts for nearly 30% of domestic value added, a share even greater than that for a smaller economy like Korea (Chart 13). Moreover, road vehicles, machinery and other transport equipment, as well as chemicals and related products, account for 53% of Germany’s exports. These products are all particularly sensitive to the global business cycle. They will therefore enhance the performance of the German economy over the next two years. Trade with the rest of Europe constitutes another boost to Germany’s economy going forward. Shipments to the euro area and the rest of the EU account for 34% and 23% of Germany’s exports, or 57% overall. Right now, the lagging economy of Europe is a handicap for Germany; however, Europe has more pent-up demand than the US, and the consumption of durable goods will surge once the vaccination campaign progresses further (Chart 14). This will create a significant boon for Germany, since we expect European consumption to pick up meaningfully over the coming 12 to 18 months.5 Chart 13Germany Depends On Global Trade Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Chart 14Europe Has More Pent-Up Demand Than The US Europe Has More Pent-Up Demand Than The US Europe Has More Pent-Up Demand Than The US Chart 15Vaccination Progress Vaccination Progress Vaccination Progress Domestic forces also point toward a strong Germany economy, not just foreign factors. The pace of vaccination is rapidly accelerating in Germany (Chart 15). The recent announcement of 50 million additional doses purchases for the quarter and up to 1.8 billion more doses over the next two years by the EU points to further improvements. A more broad-based vaccination effort will catalyze underlying tailwinds to consumption. German household income will also progress significantly. The Kurzarbeit program was instrumental in containing the unemployment rate during the crisis, which only peaked at 6.4% from 5% in early 2020. However, the program could not prevent a sharp decline in total hours worked of 7%, since by definition, it forced six million employees to work reduced hours (Chart 16). One of the great benefits of the program is that it prevents a rupture of the link between workers and employers. Thus, the economy suffers less frictional unemployment as activity recovers and household income does not suffer long lasting damage. Meanwhile, the German government is likely to extend the support for households and businesses as a result of the delayed use of the debt-brake. The Greens propose revising the debt brake rather than restoring it in 2022 like the conservatives pledge to do. Chart 16Kurtzarbeit Saved The Day Kurtzarbeit Saved The Day Kurtzarbeit Saved The Day The balance-sheet strength of German households means that they will have the wherewithal to spend these growing incomes. Residential real estate prices are rising at an 8% annual pace, which is pushing the asset-to-disposable income ratio to record highs. Meanwhile, the debt-to-assets ratio, and the level of interest rates are also very low, which means that the burden of serving existing liabilities is minimal (Chart 17). In this context, durable goods spending will accelerate, which will lift overall cyclical spending, even if German households do not spend much of the EUR120 billion in excess savings built up over the past year. As Chart 18 shows, while US durable goods spending has already overtaken its pre-COVID highs, Germany’s continues to linger near its long-term trend. Thus, as the economy re-opens this summer, and income and employment increase, the concurrent surge in consumer confidence will allow for a recovery in cyclical spending. Chart 17Strong Household Balance Sheets Strong Household Balance Sheets Strong Household Balance Sheets Chart 18Germany Too Has More Pent-up Demand Than The US Germany Too Has More Pent-up Demand Than The US Germany Too Has More Pent-up Demand Than The US Chart 19Positive Message From Many Indicators Positive Message From Many Indicators Positive Message From Many Indicators Various economic indicators are already pointing toward the coming German economic boom.Manufacturing orders are strong, and economic sentiment confidence is rising across most sectors. Meanwhile, consumer optimism is forming a trough, and new car registrations are climbing rapidly. Most positively, the stocks of finished goods have collapsed, which suggests that production will be ramped up to fulfill future demand (Chart 19). Bottom Line: The German economy is set to accelerate in the second half of the year and into 2022. As usual, Germany will enjoy a healthy dividend from robust global growth, but the expanding vaccination program, as well durable employee-employer relations, strong household balance sheets, and significant pent-up demand for durable goods will also fuel the domestic economy. Our base case scenario that fiscal policy will remain accommodative in the wake of a political shift to the left in Berlin in September will only supercharge this inevitable recovery. … And The Long-Term In contrast to the bright near-term perspective, the long-term outlook for the German economy remains poor. The policies of any new ruling coalition are unlikely to address the problems of Germany’s poor demography, deteriorating productivity, and large excess savings. There is potential for a productivity boost in the context of a global green energy and high-tech race but for now that remains a matter of speculation. The most obvious issue facing Germany is its ageing population, counterbalanced by its fertility rate of only 1.6. Over the course of the next three decades, Germany’s dependency ratio will surge to 80%, driven by an increase in the elderly dependency ratio of 20% (Chart 20). The working age population is set to decline by 18% by 2050, which will curtail potential GDP growth. The outlook for German productivity growth is also poor. Germany’s productivity growth has been in a long-term decline, falling from 5% in 1975 to less than 1% in 2019. Contrary to commonly-held ideas, from 1999 to 2007, German labor productivity growth has only matched that of France or Spain; since 2008, it has lagged behind these two nations, although it has bested Italy. One crucial reason for Germany’s uninspiring productivity performance is a lack of investment. Some of this reflects the country’s austere fiscal policy. For example, in 2019, Germany’s public investment stood at 2.4% of GDP, which compares poorly to the OECD’s average of 3.8%, or even to that of the US, where public investment stood at 3.6% of GDP. This poor statistic does not even account for the depreciation of the German public capital stock. Since the introduction of the euro, net public investment has averaged 0.03% of GDP. The biggest problem remains at the municipal level. From 2012 to 2019, federal and state level net investment averaged 0.2% of GDP, while municipal net investment subtracted 0.2% of GDP on average. Hopefully, the new government will be able to address this deficiency of the German economy. The Greens are most proactive but they will face obstacles. The bigger problem for German productivity is corporate capex. Corporate investments have been low in this country. Since the introduction of the euro, the contribution of capital intensity to productivity in Germany has equaled that of Italy and has underperformed France and Spain. As a result, the age of the German capital stock is at a record high and stands well above the US or Eurozone average (Chart 21). Chart 20Germany Has Poor Demographics Germany Has Poor Demographics Germany Has Poor Demographics Chart 21Germany's Capital Stock Is Ageing Germany's Capital Stock Is Ageing Germany's Capital Stock Is Ageing The make-up of Germany’s capex aggravates the productivity-handicap. According to a Bundesbank study, the contribution to labor productivity from information and communication technology (ICT) capital spending has averaged 0.05 percentage points annually from 2008 to 2012. On this metric, Germany lagged behind France and the US, but still bested Italy. From 2013 to 2017, the contribution of ICT investment to productivity fell to 0.02 percentage points, still below France and the US, but in line with Italy. Looking at the absolute level of ICT or knowledge-based capital (KBC) investment further highlights Germany’s challenge. In 2016, total investment in ICT equipment, software and database, R&D and intellectual property products, and other KBC assets (which include organizational capital and training) represented less than 8% of GDP. In France, the US, or Sweden, these outlays accounted for 11%, 12%, and 13% of GDP, respectively (Chart 22, top panel). This lack of investment directly hurts Germany’s capacity to innovate. The bottom panel of Chart 22 shows that, for the eight most important categories of ICT patents (accounting for 80% of total ICT patents), Germany remarkably lags behind the US, Japan, Korea, or China. Chart 22Germany Lags In ICT investment Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green A major source of Germany’s handicap in ICT and KBC investment comes from small businesses, which have been particularly reluctant to deploy capital. A study by the OECD shows that, between 2010 and 2019, the gap of ICT tools and activities adoption between Germany’s small and large companies deteriorated relative to the OECD average (Chart 23). The lack of venture capital investing probably exacerbates these problems. In 2019, venture capital investing accounted for 0.06% of Germany’s GDP. This is below the level of venture investing in France or the UK (0.08% and 0.1% of GDP, respectively), let alone South Korea, Canada, Israel, or the US (0.16%, 0.2%, 0.4% and 0.65%, respectively). The Greens claim they will create new venture capital funds but their capability in this domain is questionable. Chart 23The Lagging ICT Capabilities Of Small German Businesses Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Since Germany’s productivity growth is likely to remain sub-par compared to rest of the OECD and to lag behind even that of France or the UK, the only way for Germany to protect its competitiveness will be to control costs. This means that Germany cannot allow its recent loss of competitiveness to continue much further (Chart 24). Thus, low productivity growth will limit Germany’s real wages. Chart 24Germany's Competitiveness Is Declining Germany's Competitiveness Is Declining Germany's Competitiveness Is Declining This wage constraint will negatively impact consumption. Beyond a pop over the coming 12 to 24 months, German consumption is likely to remain depressed, as it was in the first decade and a half of the century, following the Hartz IV labor market reforms that also hurt real wages. The Greens for their part aim to boost welfare payments, raise the minimum wage, and reduce enforcement of Hartz IV. Bottom Line: German excess savings will remain wide on a structural basis. Without a meaningful pick-up in capex, German nonfinancial businesses will remain net lenders. Meanwhile, households that were worried about their financial future in a world of low real-wage growth will also continue to save a significant share of their income. Consequently, the excess savings Germany developed since the turn of the millennia are here to stay (Chart 25). In other words, Germany will continue to sport a large current account surplus and exert a deflationary influence on Europe and the rest of the world. The policy prescribed by the various parties contesting the September election will not necessarily result in new laws that will reverse the issues of low capex and low ICT investment. The Greens will worsen the over-regulation of the economy. Barring a policy revolution that succeeds in all its aims (a tall order), we can expect more of the same for Germany – that is, a slowly declining economy. Chart 25Too Much Savings, Not Enough Investments Too Much Savings, Not Enough Investments Too Much Savings, Not Enough Investments Chart 26Germany Scores Well On Renewable Power Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green That being said, some bright spots exist. Germany is becoming a leader in renewable energy, and it can capitalize on the broadening of this trend to enlarge its export market (Chart 26). Investment Implications Bond Markets The economic outlook for Germany and the euro area at large is consistent with the underweighting of German bunds within European fixed-income portfolios. Bunds rank among the most expensive bond markets in the world, which will make them extremely vulnerable to positive economic surprise in Europe later this year, especially if Germany’s fiscal policy loosens up further in the wake of the September election (Chart 27). Moreover, easier German fiscal policy should help European peripheral bonds, especially the inexpensive Italian BTPs that the ECB currently buys aggressively. Thus, we continue to overweight BTPs, and add Greek and Portuguese bonds to the list. Chart 27German Bunds Are Expensive Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Chart 28German Yields Already Embed Plenty Pessimism About Europe German Yields Already Embed Plenty Pessimism About Europe German Yields Already Embed Plenty Pessimism About Europe Relative to US Treasurys, the outlook for Bunds is more complex. On the one hand, the ECB will not tighten policy as much as the Fed later this cycle; moreover, European inflation is likely to remain below US levels this year, as well as through the business cycle. On the other hand, Bunds already embed a significantly lower real terminal rate proxy and term premium than Treasury Notes (Chart 28). Netting it all out, BCA Research Global Fixed Income Strategy service believes Bunds should outperform Treasurys this year, because they have a lower beta, which is a valuable feature in a rising yield environment.6 We will closely monitor risks around this view, because it is likely that the European economic recovery will be the catalyst for the next up leg in global yields, in which case German bunds could temporarily underperform. On a structural basis, as long as Germany’s productivity issues are not addressed by Berlin, German Bunds are likely to remain an anchor for global yields. Germany will remain awash in excess savings, which will act as a deflationary anchor, while also limiting the long-term upside for European real rates. Excess savings results in a large current account surplus; thus, Germany will continue to export its savings abroad and act as a containing factor for global yields. The Euro The medium-term outlook points to significant euro upside. Our expectation of a European and German positive growth surprise over the coming 12 months is consistent with an outperformance of the euro. The fact that investors have been moving funds out of the Eurozone and into the US at an almost constant rate for the past 10 years only lends credence to this argument (Chart 29). Our view on Germany’s fiscal policy contributes to the euro’s luster. Greater German budget deficits help European economic activity and curtail risk premia across the Eurozone. This process is doubly positive for the euro. First, lower risk premia in the periphery invite inflows into the euro area, especially since Greek, Portuguese, Italian, or Spanish yields offer better value than alternatives. Second, stronger growth and lower risk premia relieve pressure on the ECB as the sole reflator for the Eurozone. At the margin, this process should boost the extremely depressed terminal rate proxy for Europe and help EUR/USD. Robust global economic activity adds to the euro’s appeal, beyond the positive domestic forces at play in Europe. The dollar is a countercyclical currency; thus, global business cycle upswings coincide with a weak USD, which increases EUR/USD’s appeal. Nonetheless, if the boost to global activity emanates from the US, then the dollar can strengthen. This phenomenon was at play in the first quarter of 2021. However, the global growth leadership is set to move away from the US over the next 12 months, which implies that the normal inverse relationship between the dollar and global growth will reassert itself to the euro’s benefit. The European balance of payments dynamics will consolidate the attraction of the euro. Germany’s and the Eurozone’s current account surplus will remain wide, especially in comparison to the expanding twin deficit plaguing the US. Beyond the next 12 to 24 months, the lack of structural vigor of Germany’s and Europe’s economy is likely to shift the euro into a safe-haven currency, like the yen and the Swiss franc. A strong balance of payments and low interest rates (all symptoms of excess savings) are the defining features of funding currencies, and will be permanent attributes of the euro area if reforms do not address its productivity malaise. The Eurozone’s net international position is already rising and its low inflation will put a structural upward bias to the Euro’s purchasing power parity estimates (Chart 30). Those developments have all been evident in Japan and Switzerland, and will likely extinguish the euro’s pro-cyclicality as time passes. Chart 29Investors Already Underweight European Assets Investors Already Underweight European Assets Investors Already Underweight European Assets Chart 30Upward Bias In The Euro's Fair Value Upward Bias In The Euro's Fair Value Upward Bias In The Euro's Fair Value Chart 31Germany Has Not Outperformed The Rest Of The Eurozone Germany Has Not Outperformed The Rest Of The Eurozone Germany Has Not Outperformed The Rest Of The Eurozone German Equities In absolute terms, the DAX and German equities still possess ample upside over the next 12 to 24 months. BCA Research is assuming a positive stance on equities, and a high beta market like Germany stands to benefit.7 Moreover, the elevated sensitivity to global economic activity of German equities accentuate their appeal. BCA Research likes European stocks, and German ones are no exception.8 The more complex question is how to position German equities within a European stock portfolio. After massively outperforming from 2003 to 2012, German equities have moved in line with the rest of the Eurozone ever since (Chart 31). Moreover, German equities now trade at a discount on all the major valuation metrics relative to the rest of the Eurozone (Chart 31, bottom panel). The global macro forces that dictate the outlook for German equities relative to the rest of the Eurozone are currently sending conflicting messages. On the one hand, German equities normally outperform when commodity prices rally or when the euro appreciates (Chart 32). On the other hand, however, German equities also underperform when global yields rise, or following periods when Chinese excess reserves fall, such as what we are witnessing today. With this lack of clarity from global forces, the answer to Germany’s relative performance question lies within European economic dynamics. Germany is losing competitiveness relative to the rest of the Eurozone (Chart 24 page 22) which suggests that German stocks will benefit less than their peers from a stronger euro in comparison to their performance in the last decade. Moreover, German equities outperform when the German manufacturing PMI increases relative to that of the broad euro area. The gap between the German and euro area manufacturing PMI stands near record highs and is likely to narrow as the rest of the Eurozone catches up. This should have a bearing on the performance of German stocks (Chart 33). Chart 32Mixed Global Backdrop For Germany's Relative Performance Mixed Global Backdrop For Germany's Relative Performance Mixed Global Backdrop For Germany's Relative Performance Chart 33A European Economic Catch-Up Would Hurt German Equities A European Economic Catch-Up Would Hurt German Equities A European Economic Catch-Up Would Hurt German Equities Finally, sectoral dynamics may prove to be the ultimate arbiter. Table 4 highlights the limited difference in sectoral weightings between Germany and the rest of the Eurozone, which helps explain the stability in the relative performance over the past nine years. However, the variance is greater between Germany and specific European nations. In this approach, BCA’s negative stance on growth stocks correlates with an overweight of Germany relative to the Netherlands. Moreover, our positive outlook on financials and bond yields suggests that Germany should underperform Italian and Spanish stocks. Table 4Sectoral Breakdown Across Europe Major Bourses Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Appendix: Global Climate Policy Commitments Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Footnotes 1 See Matthew Karnitschnig, "German Conservatives Mired In ‘The Swamp,’" Politico, March 24, 2021, politico.eu. 2 The Greens are interested in a range of taxes, including a carbon tax, a digital services tax, and a financial transactions tax. They are also interested in industrial quotas requiring steel and car makers to sell a certain proportion of carbon-neutral steel and electric vehicles. See an excellent interview with Ms. Baerbock in Ileana Grabitz and Katharina Schuler, "I don’t have to convert the SUV driver in Prenzlauer Berg," Zeit Online, January 2, 2020, zeit.de. 3 See her comments to Zeit Online. 4 Please see BCA Research Global Investment Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 5 Please see BCA Research European Investment Strategy Special Report "A Temporary Decoupling", dated April 5, 2021, available at eis.bcareseach.com. 6 Please see BCA Research Global Fixed Income Strategy Strategy Report "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcareseach.com. 7 Please see BCA Research Global Income Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 8 Please see BCA Research European Income Strategy Strategy Report "Time And Attraction", dated April 12, 2021, available at eis.bcareseach.com.

Pocketing 42% In Combined Gains Pocketing 42% In Combined Gains On Tuesday, our 5% rolling stop on the long “Back-To-Work”/short “COIVD-19 Winners” baskets pair trade was triggered. We are obeying the stop and closing the trade for another 20.5% return on top of the previous 21.5%, which brings the total return to 42% in under 9 months. While we are not changing our 2021 overlapping theme of economic reopening that underpinned this trade, we are no longer content with the risk/reward tradeoff, and from a risk management portfolio perspective choose to obey our stop and step aside. Granted, if the share price ratio goes through a meaningful correction catalyzed by the dormant US 10-year Treasury yield, we will reopen this trade once again looking for a new leg higher. Bottom Line: Close the long “Back-To-Work”/short “COIVD-19 Winners” baskets pair trade for a gain of 20.5%, since the second inception, but stay tuned.  

While the Fed remains committed to ZIRP for the remainder of the year, already FOMC members started talking about talking about tapering. The next logical step is for tapering to become reality as the year draws to a close or early in 2022. Peering above the 49th parallel, the BoC yesterday opted to taper bond purchases, albeit slightly, and may offer a glimpse of what may also take root in the US in the not too distant future. True, tapering is a good thing as the Central Bank’s (CB) confidence is high that the economy is on a solid footing and no longer needs additional CB support, however if history is an accurate guide, equity investors will have to digest the tapering news once it becomes reality. The chart shows G4 CB liquidity as a 26-week change in the asset side of the balance sheet, and given that some of this excess liquidity seeps over to the US equity market, its withdrawal will likely prove tumultuous. Bottom Line: Near-term caution is warranted on the prospects of the broad equity market that remains fully valued. Please see the next US equity sector Insight. What To Make Of Waning Global Central Bank Liquidity? What To Make Of Waning Global Central Bank Liquidity?

Highlights Surging Covid-19 cases to unprecedented levels have unsettled India’s equity and currency markets. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential ongoing super-spreader events. Yet, the country’s medium- and longer-term outlooks remain positive. Asset allocators with less tolerance for volatility may tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Feature New COVID-19 cases in India have skyrocketed in the past few weeks – far surpassing previous peaks. The country now accounts for 40% of daily new cases globally (Charts 1 and 2). This has raised the possibility of fresh lockdowns and, as a result, Indian stocks and the currency have begun to sell off. Chart 1Daily COVID-19 Cases Have Lately Skyrocketed In India … India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Chart 2… Accounting For 40% Of Global Cases And 20% Of Deaths … India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade We have been overweight India in an EM equity portfolio because of the country’s positive cyclical and structural outlook. Even though our views have not changed, we believe the parabolic surge in COVID-19 cases is likely to cause near-term volatility in Indian equity and currency markets. As such, we recommend that asset allocators who have less tolerance for volatility tactically downgrade Indian equities to neutral for the next couple of months. Below we elaborate the reasons for this near-term downgrade, as well as the reasons for our more upbeat view over the medium to long term. New Cases Might Stay High Chart 3… And Raising The Specter Of Another Stringent Lockdown India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Being a densely populated country with less than ideal living conditions, the attempts to control the spread of COVID-19 via social distancing measures is extremely difficult in India. Yet, the authorities tried to do exactly that last spring by imposing the most stringent lockdown measures anywhere in the world (Chart 3). The result was a complete collapse in economic activity: year-over-year industrial production fell by a half, and GDP contracted by 22% in the second quarter of 2020 from a year ago. Now facing an unprecedented surge in new cases, markets are apprehensive that even a partial lockdown will scuttle the nascent recovery in the economy. Worryingly, the number of new cases in India might stay exceptionally high for a while. The reason is that there are several potential super-spreader events going on. The country is undergoing state-level elections in five states where the candidates are canvassing in front of gatherings of tens of thousands of people. Currently, there is also a religious congregation taking place where up to three million pilgrims have assembled. Chart 4Should Morbidity And Mortality Rates Rise, A Harsh Lockdown May Become Inevitable India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade The morbidity and mortality rates have not yet risen (Chart 4). This is a key metric and will likely determine the stringency of the authorities’ lockdown measures. Even though the Prime Minister has declared that stern lockdowns would be last-resort measures, the possibility cannot be excluded if hospitalization and mortality rates begin to rise. The following has also added to investor concerns: The fact that equity valuations are much higher now than they were last spring makes the market even more prone to a setback (Chart 5). Indian stocks have benefitted from a record amount of foreign portfolio inflows over the past 12 months – totaling $ 34 billion. The risk is therefore high that some of these flows might reverse in the near term if the threat of renewed lockdowns is realized. That will be a headwind for both stock market and the rupee (Chart 6). Finally, a rising US dollar, and a likely general underperformance of EM stocks over the next several months, will also encourage outflows from India. Chart 5Elevated Valuations Have Added To The Vulnerability Of Indian Stocks India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Chart 6A Reversal In Foreign Portfolio Inflows Will Cause Both Stocks And The Rupee To Fall India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Cyclical Outlook Remains Positive Beyond the near-term jitters, India’s cyclical outlook remains positive. The recovery has been solid as indicated by the following metrics: The number of E-way bills issued (a barometer of business activity) as part of the Goods & Services Tax (GST) collection mechanism keeps rising steadily. GST collection itself has also been strong – validating the same message (Chart 7). Manufacturing and Services PMIs printed over 55 in March – indicating robust expansion of activity. Order books of companies, as indicated by both RBI and Dun & Bradstreet surveys, look strong. These indicators herald an improvement in industrial production going forward (Chart 8). Chart 7Underlying Economic Recovery In India Has Been Robust So Far … India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Chart 8… Supported By Strong Order Books … India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade In short, all of the above points to an ameliorating top lines (sales) for the corporates in the coming months, barring stringent lockdowns. Meanwhile, firms’ profits margins have also recovered meaningfully. An RBI survey of over 2600 companies shows that both gross and net profit margins had risen to above pre-pandemic levels by December 2020 (Chart 9). Given the wide margins, a recovery in sales levels will lead to accelerating profits in the quarters ahead. In a sign that profit re-acceleration is not far off, firms have begun to invest in new plants and machinery. Capital spending had already turned positive during the last quarter of 2020 versus the same period of 2019. Imports of capital goods have also begun to rise – corroborating new capex plans of the firms (Chart 10). Chart 9… And Healthy Profit Margins … India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Chart 10… Which Have Encouraged Firms To Resume Capital Spending India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade New capital expenditure is undertaken only when firms are confident of strengthening demand. Besides, capex usually comes on the heels of rising profits. Higher capital goods imports and capital spending therefore indicate that the companies are optimistic of both sales and profits going forward. On its part, the central bank has ensured that the liquidity in the banking system remains abundant by engaging in plenty of open market operations. Bank credit growth, at 6.3%, is still low, but appears to have bottomed. Excluding the credit to large corporations – who have in recent years been replacing bank credit by local currency debt issuances – the credit growth rate is 9% (Chart 11). Odds are that beyond the near-term jitters due to rising COVID-19 cases, credit will accelerate in line with recovering economic activity. That will be bullish for bank stocks. Incidentally, banks make up the largest chunk of Indian equity index. Finally, Indian small caps continue to outperform their large cap counterparts (Chart 12). Smaller firms in India are much more vulnerable to a slowdown in growth and tighter credit conditions. The fact that they keep outperforming suggests that investors do not expect a major or lasting impact of the latest pandemic outbreak on the economy. Chart 11Bank Credit Will Rise As The Expansion Continues India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Chart 12Small Caps Outperformance Suggest Investors Are Sanguine About Growth And Credit Conditions India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Beyond the cyclical recovery, we are bullish on India’s longer-term outlook as well. The reason for that is India is one of the rare EM countries undertaking meaningful structural reforms. The country’s demographics are also highly favorable. We will elaborate on these and other structural issues in greater detail in our future reports. Investment Conclusions Indian stocks and the currency have entered a period of turbulence as surging COVID-19 cases prompt profit taking/selling. EM equity portfolios with low tolerance for volatility should therefore consider tactically downgrading this bourse to neutral for a couple of months. Absolute return investors (in US$ terms) should also brace for near-term volatility in Indian share prices. Over the medium-to-long term however, Indian stocks will likely outperform their EM peers as well as rally in absolute terms (Chart 13). Indian bank stocks are also suffering from the ongoing volatility. However, given Indian private banks’ higher efficiency and better balance sheets vis-à-vis banks elsewhere in the EM, long-term investors should continue to stick with our recommended trade of long Indian banks/ short EM banks (Chart 14). Chart 13Beyond The Near-Term Volatility, Indian Stocks Will Outperform Their EM Peers … India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Chart 14… So Will Indian Bank Stocks Vis-à-vis EM Banks India Warrants A Tactical Downgrade India Warrants A Tactical Downgrade Fixed income investors should continue receiving 10-year swap rates in India. With the abundant rainfall, food prices will decline. This will keep inflation under check. The rising COVID-19 cases and a potential lockdown are disinflationary in nature and will push down swap rates.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Consumption Is Explained By Wages... Consumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks ...Not By Stimulus Checks ...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Stimulus Checks Had No Meaningful Impact On Consumption Trends Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt In Japan, Public Debt Ended Up Paying Down Private Debt In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Tech Is Expensive Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Convert The Earnings Yield Into A Prospective Nominal Return... Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Convert The Earnings Yield Into A Prospective Real Return... Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather The Rally In Equities Versus Bonds Is Due A Breather The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Underweight The PKR Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Overweight New Zealand Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations