Financial Markets

Highlights The post-pandemic investment phase is just a continuation of the post-credit boom investment phase. This is because the pandemic has just accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends will structurally weigh on the profits of old economy sectors, consumer prices, and bond yields. At the same time, these trends are a continuing structural tailwind for the profits in those sectors that facilitate the shift to a more digital and cleaner world. Our high-conviction recommendation is to stay structurally overweight growth sectors versus old economy sectors… …and to stay structurally overweight the US stock market versus the non-US stock market. Fractal analysis: PLN/USD, Hungary versus Emerging Markets, and sugar versus soybeans. Feature Chart of the WeekUS And Non-US Profits Go Their Starkly Separate Ways US And Non-US Profits Go Their Starkly Separate Ways US And Non-US Profits Go Their Starkly Separate Ways Many people use the US stock market as a proxy for the world stock market. Intuitively, this makes sense, because the US stock market is the largest in the world, and the S&P 500 and Dow Jones Industrials are well-known indexes that we can monitor in real time. In contrast, world equity indexes such as the MSCI All Country World are less familiar and do not move in real time. Yet to use the US stock market as a proxy for the world stock market is a mistake. Although the US comprises makes up half of the world stock market capitalisation, the other half is so different – the non-US yan to the US yin – that the US cannot represent the world. As we will now illustrate. US Profits Have Doubled While Non-US Profits Have Shrunk Over the past ten years, US and non-US stock market profits have gone their starkly separate ways. While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011! (Chart of the Week) While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011. Of course, in any comparison of this sort, a key issue is the starting point. In this first part of our analysis, we are defining the starting point as the point at which profits had recouped all their global financial crisis losses. For both US and non-US profits this point was in March 2011 (Chart I-2 and Chart I-3). Chart I-2Comparing Profit Growth Since The Full Recovery From The Financial Crisis Comparing Profit Growth Since The Full Recovery From The Financial Crisis Comparing Profit Growth Since The Full Recovery From The Financial Crisis Chart I-3Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Because the issue of the starting point of the analysis is contentious, we will look at a much earlier starting point later in the report. But first, here are the decompositions of the US and non-US stock market moves from March 2011. US stock market profits are up 93 percent, while the multiple paid for those profits (valuation) is up 75 percent. Compounding to a total price gain of 235 percent (Chart I-4). Chart I-4US Profits Up 93 Percent, Valuation Up 75 Percent US Profits Up 93 Percent, Valuation Up 75 Percent US Profits Up 93 Percent, Valuation Up 75 Percent Non-US stock market profits are down -9 percent, while the multiple paid for those profits is up 38 percent. Compounding to a total price gain of a measly 25 percent (Chart I-5). Chart I-5Non-US Profits Down -9 Percent, Valuation Up 38 Percent Non-US Profits Down -9 Percent, Valuation Up 38 Percent Non-US Profits Down -9 Percent, Valuation Up 38 Percent The aggregate world stock market profits are up 24 percent, while the multiple paid for those profits is up 57 percent. Compounding to a total price gain of 94 percent (Chart I-6). Chart I-6World Profits Up 24 Percent, Valuation Up 57 Percent World Profits Up 24 Percent, Valuation Up 57 Percent World Profits Up 24 Percent, Valuation Up 57 Percent The Post-Credit Boom Phase Favours The US Over The Non-US Stock Market In the post-credit boom phase, several important features of stock market performance are worth highlighting. In absolute terms, valuation expansion has lifted US stocks by twice as much as non-US stocks, 75 percent versus 38 percent. Yet even the 75 percent expansion in the US stock market valuation has played second fiddle to the 93 percent expansion in US stock market profits. Absent valuation expansion, non-US stocks would stand lower today than in 2011. But for non-US stocks, whose structural profit growth has been non-existent, valuation expansion has been the only instrument for structural gains. Indeed, absent valuation expansion, non-US stocks would stand lower today than in 2011. And absent valuation expansion at a world level, the world stock market would lose three quarters of its ten-year gain. What can explain the startling performance differential between US and non-US stocks on both profit and valuation expansions? As we have argued before, most of the difference does not come from the underlying (US versus non-US) economies, but instead comes from the company and sector compositions of the stock markets. The US stock market is heavily over-weighted to global growth companies and sectors – such as technology and healthcare (Chart I-7) – which, by definition, have experienced structural growth in their profits. In contrast, the non-US stock market is heavily over-weighted to global old economy companies and sectors – such as financials, energy, and resources (Chart I-8) – whose profits have stagnated, or entered structural downtrends (Chart I-9). Chart I-7The US Stock Market Is Heavily Over-Weighted To Growth Sectors The US Stock Market Is Heavily Over-Weighted To Growth Sectors The US Stock Market Is Heavily Over-Weighted To Growth Sectors Chart I-8The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors   Chart I-9Old Economy Sector Profits Have Gone Nowhere Old Economy Sector Profits Have Gone Nowhere Old Economy Sector Profits Have Gone Nowhere At the same time, when bond yields decline, companies whose profits are growing (and time-weighted into the distant future) see a greater increase in their net present values. Hence, companies in the global growth sectors have experienced a larger valuation expansion than those in the old economy sectors. In this way, the US stock market has outperformed the non-US stock market on both profit growth and valuation expansion. The key question is, will these post-credit boom trends continue? The answer depends on whether the post-pandemic world marks a new phase for investment, or whether it is just a continuation of the post-credit boom phase. The Post-Pandemic Phase Is A Continuation Of The Post-Credit Boom Phase Let’s now address the issue of the starting point of our analysis by panning out to 1990. This bigger picture from 1990 shows three distinct phases for investors (Chart I-10 and Chart I-11). Chart I-10Since 1990, There Have Been Three Distinct Investment Phases Since 1990, There Have Been Three Distinct Investment Phases Since 1990, There Have Been Three Distinct Investment Phases Chart I-11The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The first phase was the 1990s build-up to the dot com boom. This phase clearly favoured growth sectors, and thereby the US stock market versus the non-US stock market. The second phase was the early 2000s credit boom. This phase clearly favoured sectors that facilitated the credit boom or benefited from its spending – notably, the old economy sectors of financials, energy, and resources. Thereby it favoured the non-US stock market versus the US stock market. The third and most recent phase is the post-credit boom phase. This phase has flipped the leadership back to growth sectors as the absence of structural credit growth has stifled financials as well as the capital-intensive old economy sectors that had previously benefited from the credit boom. Additionally, the structural disinflation that has comes from weak credit growth has dragged down bond yields and – as already discussed – given a much bigger boost to growth sector valuations. Since 1990, there have been three distinct phases for investors: the dot com boom; the credit boom; and the post-credit boom. Now we come to the key question. Did 2020 mark the end of the post-credit boom phase and the start of a new ‘post-pandemic’ phase? On the evidence so far, the answer is an emphatic no. Crucially, there is no new credit boom. A still highly indebted private sector is neither willing nor able to borrow. And although public sector debt surged during the pandemic, governments are now keen to temper or rein in deficits. In any case, Japan teaches us that government borrowing – which is bond rather than bank financed – does nothing for the banks or the broader financial sector. An equally important question is, has the pandemic reversed the societal and economic trends of the post-credit boom phase? The answer is no. Quite the contrary, the pandemic has accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends are structurally disinflationary for the profits of old economy sectors as well as for consumer prices. Thereby, they will continue to weigh on bond yields. At the same time, the trends are a continuing structural tailwind for the profits in those sectors that facilitate and enable the shift to a more digital and cleaner world. While we are open to the evolving evidence, the post-pandemic investment phase seems an extension of the post-credit boom phase. This means that structurally, there is no reason to flip out of growth sectors back to old economy sectors. It also means that structurally, there is no reason to switch from US to non-US stocks. Fractal Analysis Update This week’s fractal analysis highlights three potential countertrend moves based on fragile fractal structures. First, the recent rally in the US dollar could meet near-term resistance given its weakening 65-day fractal structure. A good way of playing this would be long PLN/USD (Chart I-12). Chart I-12PLN/USD Could Rebound PLN/USD Could Rebound PLN/USD Could Rebound Second, the strong outperformance of Hungary versus Emerging Markets – largely driven by one stock, OTP Bank – has become a crowded trade based on its 130-day fractal structure. This would suggest underweighting Hungary versus the Emerging Markets index (Chart I-13). Chart I-13Underweight Hungary Versus EM Underweight Hungary Versus EM Underweight Hungary Versus EM Finally, the sugar price has skyrocketed as extreme weather has disrupted output in the world’s top producer, Brazil. Given that supply bottlenecks ultimately ease, a recommended trade would be to short sugar versus soybeans, using ICE versus CBOT futures contracts (Chart I-14). Set the profit target and symmetrical stop-loss at 8 percent. Chart I-14Short Sugar Versus Soybeans Short Sugar Versus Soybeans Short Sugar Versus Soybeans 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 Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators 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 Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators 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 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas China Spreads The Wealth Around China Spreads The Wealth Around Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 China Spreads The Wealth Around China Spreads The Wealth Around Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade China Spreads The Wealth Around China Spreads The Wealth Around While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan China Spreads The Wealth Around China Spreads The Wealth Around Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) China Spreads The Wealth Around China Spreads The Wealth Around Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

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

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? China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 2Reconciliation Bill Also Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 3Biden Cannot Spare A Single Vote In Senate China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 … China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden 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 Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia'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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China'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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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? German Election Polls Point To Gridlock? German 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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients 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 Geopolitical Tailwinds To European Equities Geopolitical 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 China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 13Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Japan 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 Last week’s market gyrations do not mark the end of China’s structural reforms. The country’s macro policy setting has shifted to allow a higher tolerance for short-term pain in exchange for long-term gain. Chinese policymakers will temporarily put the brakes on its reform agenda if policy measures threaten domestic economic stability; a spillover from the equity market rout to the currency market and private-sector investment will be a pressure point for the authorities. Messages from last week’s Politburo meeting were only marginally more positive than in April. While policymakers seem to be paying more attention to the economic slowdown, they do not appear to be in a rush to rescue the economy. We present three scenarios describing how the equity markets and policy may develop in the coming months. In all the scenarios, investors should avoid trying to catch a falling knife. Feature July was an extraordinarily difficult time for Chinese stocks and last week’s steep slide intensified as a slew of announced regulatory changes spooked market participants (Chart 1). Chart 1Chinese Stocks Had A Tough Month Pricing A Tighter Regulatory Grip Pricing A Tighter Regulatory Grip We have repeatedly outlined the risks to Chinese equities in the past month. Since the PBoC cut the reserve requirement ratio in early July, the negative impact on the financial markets from tightening industry policies has outweighed the limited positive effects from a slightly more dovish central bank policy stance.  Chart 2Chinese TMT Stock Prices Were Hammered Chinese TMT Stock Prices Were Hammered Chinese TMT Stock Prices Were Hammered Is now a good time to buy Chinese stocks? Multiple compressions have made Chinese equities, particularly the hard-hit technology, media & telecom (TMT) stocks in the offshore market, appear cheap compared with their global counterparts (Chart 2). In this report we present three scenarios how China’s equity market and policies will likely evolve. In our view, more than a week of stock selloffs will be needed for policymakers to halt reforms. Furthermore, even if the pace of reforms eases and policymakers start to reflate the economy, it will likely take between 6 and 12 months for stock prices to find a bottom.  In light of escalating uncertainty over China’s financial market performance, the China Investment Strategy and Global Asset Allocation services will jointly publish a Special Report on August 18. We will examine how global investors can improve the risk-reward profile of their multi-asset portfolios with exposure to Chinese assets.   Three Scenarios While the regulatory landscape is unclear, we can draw on previous experience to analyze how China’s equity market and policy directions may evolve. In the first scenario, which is our baseline case, the economy would weaken, but would not cross policymakers’ pain threshold. There would be marginal policy easing action to alleviate market anxiety and monetary policy would be slightly loosened along with polices on some non-core sectors, such as infrastructure investment. In this scenario, structural reforms could continue for another 6 to 12 months, as suggested by colleagues at the BCA Geopolitical Strategy services. Investors should resist the urge to buy on the dip. Investors would be kept on edge by a confluence of a slowing economy (even though the slowdown is measured) and heighted regulatory oversight. The market would oscillate between technical rebounds when macro policy eases and selloffs when industry regulations tighten. There are two reasons why the pace of regulatory tightening will not moderate in the near term. First, China’s economic policy has shifted from setting an annual economic growth target to multi-year planning. This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits. Despite a deep dive in stock prices last week, China’s bond and currency markets have been stable relative to the market gyrations in both 2015 and 2018 (Chart 3A and 3B).  Furthermore, the newly released PMIs and recent economic data show that the China’s economic activity is weakening, but the speed of softening seems to be within the policymakers’ comfort zone (Chart 4). Chart 3AChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 3BChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 4Economic Pain Has Not Crossed Policymakers' Threshold Economic Pain Has Not Crossed Policymakers' Threshold Economic Pain Has Not Crossed Policymakers' Threshold Secondly, the new rules imposed on industries - ranging from internet, property, education, healthcare to capital markets - are part of China’s long-term structural reform agenda outlined in the 14th Five-Year Plan (FYP).  As China transitions from building a "moderately prosperous society" by 2020 to becoming a "great modern socialist nation" by 2049, the country’s policy priority has shifted from a rapid accumulation of wealth to addressing income inequality and social welfare for average households.  The policy objective is not only to close regulatory loopholes and end the disorderly expansion of capital and market shares, but also assign a larger weight of social equality and responsibility to the private sector’s business practices. The pace in achieving this overarching goal will only moderate when China’s economy and financial markets show meaningful signs of stress. The second possibility would be if policymakers fail to restore investors’ confidence. Foreign and domestic investors would reassess China’s policy directions and reprice the outlook for corporate profit growth. Market selloffs would continue, like in 2015 and 2018 following policy shocks,1 equity market gyrations would spill over to the currency market through capital outflows and real economic sectors through dwindling investment (Chart 5). In this scenario, Chinese policymakers would likely abandon their reform agenda, at least temporarily, and decisively shift policy to reflate the economy (Chart 6). Chart 5Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Chart 6...Triggering Decisive Reflationary Policy Responses ...Triggering Decisive Reflationary Policy Responses ...Triggering Decisive Reflationary Policy Responses A third scenario would be if China is challenged by the external environment, either due to a significant increase in geopolitical conflicts or a widespread resurgence of new COVID cases. Both aspects would pose sizable downside risks to China’s economic activity. The risks would force authorities to shift to an easier stance and slow the pace of domestic reforms. Chart 7It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out In the second and third scenarios, the rout in the equity market would likely deepen in the near term, before prices bottom in response to a halt in regulatory crackdowns and a decisive turn to reflationary measures. As illustrated in Chart 7, in both 2015 and 2018, it took 6 to 12 months and significant stimulus for Chinese stock prices to bottom in absolute terms. Bottom Line: Our baseline scenario suggests a continuation of structural reforms. Investors should refrain from jumping into the market until there are firm signs that regulatory tightening is over and reflationary measures have started. Key Messages From The Politburo Meeting Last week’s much-anticipated Politburo meeting, chaired by President Xi Jinping, adopted a slightly more dovish tone towards macroeconomic policy than in April, but also indicated that the leadership will stick to its long-term reform agenda. The stance was mildly positive for the overall economy and financial markets. Macro policies in some non-core sectors, such as infrastructure investment, will likely ease at the margin during the rest of the year. However, the meeting’s statement warned “a more complex and challenging external environment” lies ahead, which indicates that heightened concerns over geopolitical tensions will only exacerbate regulatory oversights in data and national security.  Regarding fiscal policy in 2H21, the authorities seem to be growing more concerned about growth outlook.  The meeting mentioned that fiscal support should make “reasonable progress” later this year and early next year. The pace of local government special purpose bond (SPB) issuance will pick up in Q3 and into Q4. However, we maintain our view that without a significant rise in bank credit growth, an acceleration in SPB issuance will only provide a moderate boost to local infrastructure spending. The reference to cross-cycle policy adjustment from the meeting readout is also in line with our view that policymakers may save their fiscal ammunition for next year when the economy comes under greater downward pressure. Odds are rising that the authorities will allow a frontloading of SPBs in Q1 2022 before the National People’s Congress in March next year. The statement also notably mentioned that government officials shall “ensure the supply of commodities and stabilize prices" and called for a more rational pace in carbon reduction. We think this message implies a temporary easing of production curbs in some heavy industries, such as steel, coal, and possibly a further release of strategic reserves of industrial metals (Chart 8A and 8B). The supply-side policy shift should add downward pressure on global industrial prices in addition to the ongoing slowdown in demand from China (Chart 9). Chart 8ASome Backpaddling Likely In Decarbonization Progress Some Backpaddling Likely In Decarbonization Progress Some Backpaddling Likely In Decarbonization Progress Chart 8BSome Backpaddling Likely In Decarbonization Progress Some Backpaddling Likely In Decarbonization Progress Some Backpaddling Likely In Decarbonization Progress Chart 9Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Meanwhile, the meeting repeated the "three stabilization” policy, which targets stabilizing land prices, housing prices and property market expectations. This sends a strong signal that policymakers are unwilling to soften the tone on restrictions in the housing market. Bottom Line: The July Politburo meeting’s messaging was only modestly more dovish than three months ago. Investment Implications Chinese offshore stocks have fallen by 26% from their February peak, compared with approximately 14% for onshore stocks. The offshore TMT stocks are approaching their long-term technical resistance, measured by the three-year moving average in prices (Chart 10). While the magnitude of last week’s stock price decline seems excessive relative to previous market selloffs, the multiple compression reflects considerable uncertainty surrounding the outlook for China’s policy direction. New antitrust regulations in China are intended to limit the monopolistic business practices of internet companies. As a result, these companies’ operational costs will rise and profit growth will decline, and their valuations will converge with those of non-TMT companies. The trailing P/E ratio in Chinese investable TMT stocks is still elevated, making the equities vulnerable to further regulatory tightening and multiple compressions (Chart 11). Chart 10Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chart 11...But Still Vulnerable To Further Multiple Compression ...But Still Vulnerable To Further Multiple Compression ...But Still Vulnerable To Further Multiple Compression     Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1On August 11, 2015, the PBOC surprised the market with three consecutive devaluations of the Chinese yuan, knocking over 3% off its value. On April 3, 2018 former US President Donald Trump unveiled plans for 25% tariffs on about $50 billion of Chinese imports. Market/Sector Recommendations Cyclical Investment Stance

Highlights China’s broad equity market performance since the PBoC cut its reserve requirement ratio (RRR) is consistent with our view. While the central bank’s policy tone remains dovish, a single reduction in the RRR rate has a limited impact on the economy. Divergent sector performance points to an ongoing pressure for structural reforms, ranging from traditional economic pillars to some of the new economy sectors. The bond market is betting on more rate cuts. While we expect more monetary policy easing later this year, the bond market may be ahead of itself and vulnerable to a near-term reassessment of policy and growth.  Stay underweight Chinese stocks until sure signs of policy easing emerge. Feature Chart 1Overexcited Bond buyers, Unimpressed Equity Investors Messages From The Market Messages From The Market China’s bond markets rallied in the two weeks following the PBoC’s 50bps reduction in the RRR. The A-share market, on the other hand, moved sideways until the big selloff earlier this week (Chart 1). Chinese policymakers’ continued crackdown on internet companies forced offshore Chinese equities to drop by 13% so far in July.  As we previously highlighted, a single RRR cut, at the most, represents a continuation in the central bank’s dovish policy stance.Meanwhile, China continues to push for structural reforms and shows no signs of easing industry regulations. In this week's report, we review the response of investors to the RRR cut and recent policy moves, both at the broad market and sector levels. We expect that China’s macro policy measures will eventually become more reflationary to shore up domestic demand next year. However, to change our underweight stance on Chinese stocks, we would need more evidence before concluding that policies on the macro level have eased enough and will lead to a cyclical uptrend in the country’s economy. While Chinese policymakers are unlikely to lift the existing sector regulations anytime soon, the strength in policy tightening may start to moderate in the next 12 months given that regulators’ ultimate goal is to promote domestic innovation and productivity. Chinese equities, particularly the ones in the offshore market, have underperformed global stocks for most of this year. We think a bottom in Chinese stocks’ relative performance may be near, however, we recommend investors stay the course for now.  Unimpressed Equity Investors The performance in both China’s onshore and offshore equity markets suggests market participants agree with our assessment, that a single reduction in RRR does not signal the beginning of broad-based reflationary efforts by Chinese authorities. Moreover, the divergence in sector performance continues pointing to a policy pivoting away from the traditional pillars in the economy. Charts 2A and 2B present the relative performance of Chinese investable and onshore stocks versus the emerging market (EM) and global benchmarks, both in USD and rebased to 100 on the day of the RRR cut announcement. The initial reaction to the announcement was modestly positive, with Chinese equities gaining in relative terms versus their global peers. However, the small gains disappeared less than a week after the RRR’s trim, reflecting investors’ lack of confidence in the stimulative effects from a one-off cut. Chart 2AA Lackluster Offshore Equity Market... A Lackluster Offshore Equity Market... A Lackluster Offshore Equity Market... Chart 2B...The Pickup In The Onshore Market Did Not Last Long Either ...The Pickup In The Onshore Market Did Not Last Long Either ...The Pickup In The Onshore Market Did Not Last Long Either Chart 3The Real-Economy Sectors In The Offshore Market Also Underperformed The Real-Economy Sectors In The Offshore Market Also Underperformed The Real-Economy Sectors In The Offshore Market Also Underperformed China’s heightened regulatory oversight on its internet companies, including the recent clampdown on private tutoring firms, has further dampened the appetite for Chinese offshore stocks, which are concentrated in internet titans. Nonetheless, the real economy sectors in the MSCI China Index also underperformed their global peers, indicating that investors’ risk-off sentiment towards Chinese stocks is widespread (Chart 3). Furthermore, divergent sector performance is consistent with our view that it is too early to call a loosening in China’s macro policy. In addition to a continued underperformance in real estate sector stocks, domestic infrastructure stocks also failed to break above their technical resistance relative to the overall domestic market and global stocks (Charts 4A and 4B). The market signals suggest that a significant ramp up in infrastructure spending in China is not imminent. Presumably, any meaningful improvement in the country’s fiscal spending would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the domestic market and the global average. Chart 4AProperty Stocks On A Free Fall Due To Tightened Regulations Property Stocks On A Free Fall Due To Tightened Regulations Property Stocks On A Free Fall Due To Tightened Regulations Chart 4BNo Sign Of Improvement In Infrastructure Stocks No Sign Of Improvement In Infrastructure Stocks No Sign Of Improvement In Infrastructure Stocks Interestingly, the BCA China Play Index, which tracks a portfolio of assets sensitive to the outlook for Chinese growth and reflation,1 has soared since the second quarter of last year. It presents nearly a mirror image of onshore Chinese infrastructure stocks (Chart 5). Such a stark contrast in the performance between the BCA China Play Index and onshore Chinese infrastructure stocks occurred in the past and we are inclined to trust the market signals from the latter rather than the former.  The Chinese Li-Keqiang Index (LKI) of industrial activity leads the BCA China Play Index by about two to three months (Chart 6). The LKI declined non-trivially in the face of a sharp reduction in credit growth and pressing structural reforms in 1H21, suggesting that risks to the China Play Index will be to the downside in the coming months. Chart 5Which One Is Sending The Right Signal? Which One Is Sending The Right Signal? Which One Is Sending The Right Signal? Chart 6China's Li Keqiang Index May Be Flashing Amber China's Li Keqiang Index May Be Flashing Amber China's Li Keqiang Index May Be Flashing Amber On the surface, the divergence between the performance in China’s blue-chip stocks and ChiNext, a NASDAQ-style subsidiary of the Shenzhen Stock Exchange, seems consistent with falling financing costs this year (Chart 7). ChiNext is tech-heavy and sensitive to changes in interest rates.  However, ChiNext’s outperformance relative to the aggregate A-share market also reflects China’s policy direction, which is a strategic push for technology self-sufficiency and a significant increase in high-tech infrastructure investment (Chart 8).   Chart 7Chinese 'High-Tech' Stocks Benefit From Lower Rates... Chinese 'High-Tech' Stocks Benefit From Lower Rates... Chinese 'High-Tech' Stocks Benefit From Lower Rates... Chart 8...But Policy Supports Have Been A Non-Trivial Factor ...But Policy Supports Have Been A Non-Trivial Factor ...But Policy Supports Have Been A Non-Trivial Factor Bottom Line: Signals from China’s equities, both in general and on a per-sector basis, suggest that investors are not betting on a meaningful easing in the country’s policy. Making Sense Of The Bond Market The RRR cut exacerbated China’s nascent bond market rally as expectations continue to climb that additional policy easing will be forthcoming. While we agree with the bond market that China’s monetary policy will eventually turn more accommodative, the timing and speed of easing may disappoint investors. The depth in the decline of sovereign bond yields in recent weeks makes the fixed-income market vulnerable to repricing in the coming months. After hitting a peak of 3.3% in November last year, China’s 10-year government bond yield has fluctuated on a downward trend. The rollover in yields coincided with a top in several key economic indicators, such as the PMI, credit impulse and the China Economic Surprise Index (ESI) (Chart 9). Falling demand for bank credit relative to liquidity supply - indicating corporates' lower propensity to invest in the real economy - further depressed bond yields (Chart 10). Chart 9Yields Fell When The Economy Peaked Yields Fell When The Economy Peaked Yields Fell When The Economy Peaked Chart 10Lower Propensity To Invest In Real Economy Also Helped Pushing Down Bond Yields Lower Propensity To Invest In Real Economy Also Helped Pushing Down Bond Yields Lower Propensity To Invest In Real Economy Also Helped Pushing Down Bond Yields Although the momentum in China’s economic growth has peaked, the magnitude of the decline in the 10-year bond yield has likely overstated the degree of the economic slowdown. As illustrated in Chart 9, the pace of the decline in the 10-year bond yield in the past three months was as rapid as during the height of previous economic downturns.  Those economic slowdowns involved more than a single RRR cut, including the ones that coincided with the US-China trade war in 2018 and those triggered by a prolonged deflationary cycle in 2015/16. Chart 11Is The Bond Market Ahead Of Itself? Is The Bond Market Ahead Of Itself? Is The Bond Market Ahead Of Itself? From a technical perspective, the 10-year government yield has become stretched versus the underlying trend in yields as defined by the 200-day moving average (Chart 11). The steep decline in the long-date bond yield suggests that the market has priced in more potential rate cuts as well as weaknesses in China’s economy. China’s ESI, which is a gauge of market psychology, has ticked up of late. If authorities at the Politburo meeting later this month show any reluctance in further reducing rates, then a reassessment of policy will likely push up bond yields in the coming weeks. COVID-19 remains a risk to this view, however, given China’s zero tolerance towards domestic infection cases.  Even localized outbreaks will probably cause sporadic disruptions in economic activity and dampen optimism, helping to push sovereign yields even lower. Bottom Line: We remain cautious about the sustainability of the recent bond market rally, barring large disruptions caused by the COVID-19 Delta variant. The market lacks catalysts for Chinese government bond yields to trigger significant moves in either direction. Moreover, the plummet in yields in the past few weeks makes bonds vulnerable to a price correction in the near term.   Investment Conclusions While the bond market is betting on slower economic growth and more rate cuts, the timing of further policy easing is in question and the magnitude may be smaller than the market has already priced in. Meanwhile, China’s onshore and offshore market investors remain cautious, particularly given China’s renewed focus on structural reforms.  In light of these aspects, we would not recommend that investors with a time horizon of less than three months take a long position in Chinese stocks, either in absolute terms or relative to the global benchmark. However, on a cyclical (i.e. 6-12 month) time frame, we could turn more constructive on Chinese stocks if the authorities show more willingness to respond to slowing economic activity by easing policies. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1The assets included in the BCA China Play Index are: Chinese iron ore prices in USD; Swedish industrial equities in USD; Brazilian equities in USD; AUD/JPY; and EM high-yield bonds denominated in USD. Market/Sector Recommendations Cyclical Investment Stance

Highlights Portfolio Duration: The decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. Maintain below-benchmark duration in bond portfolios. US Yield Curve: Investors should position for a rebound in bond yields but not a reversal of recent US Treasury curve flattening. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. ECB: The ECB’s new forward interest rate guidance has moved it that much closer to the Fed’s ultra-accommodative stance. This reinforces the defensive nature of the European bond market. Investors should overweight European bonds within global fixed income portfolios with a particular emphasis on peripheral European bond markets like Italy and Spain. Feature Chart 1Can The Bond Rally Continue? Can The Bond Rally Continue? Can The Bond Rally Continue? The bond rally continues to rip. The selloff that started last August when Jay Powell officially announced the Federal Reserve’s adoption of an Average Inflation Target ended on March 31st 2021. Since then, the 10-year US Treasury yield has retraced from 1.74% to 1.29% and the Bloomberg Barclays US Treasury index has clawed back 285 bps of excess return versus cash, partially offsetting the 465 bps that were lost between August 2020 and March 2021 (Chart 1). The US Bond Strategy Weekly Report from two weeks ago and last week’s Global Fixed Income Strategy Weekly Report both discuss the reasons for recent bond market strength.1 We won’t re-hash those arguments this week except to reiterate our conclusion that the decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. The first section of this week’s report looks at whether correlations between different asset classes have held up during the recent bond rally, with a focus on whether those relationships give us any information about the near-term direction for bond yields. The second section considers the outlook for the slope of the US Treasury curve and the third section discusses the recently released results of the European Central Bank’s strategy review. Cross-Market Correlations During The Bond Rally The bond rally has been just as intense as the prior sell-off. The US Treasury index has outperformed a position in cash by an annualized 9% since March 31st, matching the annualized losses of 9% seen between August 2020 and March 2021 (Chart 2). An important question to answer is whether this bond market performance is consistent with other asset classes. If it is, then it may suggest that the economy is experiencing a deflationary episode and that bond yields have further downside. If it isn’t, then it is more likely that the drop in bond yields will be temporary. Chart 2Bonds Versus Credit And Equities Bonds Versus Credit And Equities Bonds Versus Credit And Equities Bonds Versus Equities And Corporate Credit Chart 3Equity Sector Performance Consistent With Yields Equity Sector Performance Consistent With Yields Equity Sector Performance Consistent With Yields Looking first at corporate bonds, we find that – consistent with stronger Treasury performance – excess US corporate bond returns have slowed since March 31st. Baa-rated corporates have been outperforming at an annualized rate of 3% since March 31st compared to an annualized rate of 12% between August 2020 and March 2021 (Chart 2, panel 2). Equities, on the other hand, have maintained their strong performance. The S&P 500 returned an annualized 30% between August 2020 and March 2021 and has returned an even greater 42% (annualized) since the end of March (Chart 2, panel 3). Extremely tight spreads are the most likely explanation for lower corporate bond excess returns. Meanwhile, the fact that equities continue to perform well is an indication that the drop in bond yields may be overdone. Interestingly, while overall equity returns haven’t dropped in line with bond yields, the relative performance of equity sectors has been totally consistent with the movement in yields (Chart 3). Cyclical equity sectors (Industrials, Energy and Materials) have underperformed defensive equity sectors (Healthcare, Telecoms, Consumer Staples and Utilities) and Banks have underperformed the overall index. The correlation between long-maturity real Treasury yields and the relative performance of value and growth stocks has also held up, with growth stocks outperforming since the end of March (Chart 3, bottom panel). Bonds Versus Commodities Chart 4Commodities And Bonds Have Diverged Commodities And Bonds Have Diverged Commodities And Bonds Have Diverged We see the biggest divergence in relative performance between bond yields and commodities. Historically, the ratio between the CRB Raw Industrials commodity price index and Gold is tightly correlated with the 10-year US Treasury yield. However, the CRB/Gold ratio has increased since the end of March while bond yields have fallen (Chart 4). In our view, this is the strongest piece of evidence suggesting that bond yields have overshot to the downside. Bonds Versus Currencies Chart 5Bonds Versus Currencies Bonds Versus Currencies Bonds Versus Currencies Finally, we observe that the US dollar has strengthened as bond yields have dropped. This is not that unusual. There are other periods when significant declines in US bond yields have coincided with dollar strength, 2019 and 2014/15 immediately come to mind (Chart 5). The common theme of those prior episodes is that the global economy was experiencing a deflationary shock. Commodity prices also fell during those periods and Emerging Market (EM) currencies depreciated versus the dollar. However, so far this year, EM currencies have held firm versus the dollar (Chart 5, bottom panel) and commodity prices continue to rise. On balance, financial markets don’t appear to be pricing-in a deflationary economic shock. In summary, since US Treasury yields peaked on March 31st, we have observed a sector rotation within US equities, but overall stock market performance has been strong. Corporate bonds continue to outperform Treasuries, though gains are limited by tight valuations. Commodity prices have held up and while the US dollar has firmed, dollar strength has not bled into EM currency weakness. All in all, we don’t view financial market performance as consistent with a deflationary economic episode. This suggests that bond yields are an outlier within the financial landscape and that the recent drop in yields won’t persist. A Quick Word On Sentiment And Positioning Chart 6A Rebound In Yields May Require A Shift In Sentiment A Rebound In Yields May Require A Shift In Sentiment A Rebound In Yields May Require A Shift In Sentiment One possible reason why bond performance has been inconsistent with some other markets is that there had simply been too much consensus around the “bond-bearish trade”. It’s certainly true that portfolio managers have been running large net-short positions and that the MarketVane survey of bond bullish sentiment is much less bullish than it was last year (Chart 6). We suspect that we may need to see bond market positioning and sentiment get more bullish before yields move meaningfully higher. Chart 6 shows that major troughs in the 30-year US Treasury yield often occur when portfolio manager positioning is “net long” bonds and when bond bullish sentiment is significantly higher than current levels. For this reason, we don’t anticipate an immediate rebound in bond yields. Rather, we suspect that yields will remain near current levels for the next month or two before strong employment data in the fall sets off the next phase of bearish bond action.   Position For A Rebound In Bond Yields, But Don’t Expect Much Curve Steepening Chart 7The 5-Year/5-Year Yield Remains Close To Target The 5-Year/5-Year Yield Remains Close To Target The 5-Year/5-Year Yield Remains Close To Target We see bond yields re-gaining their March 2021 highs, and then some, on a 6-12 month investment horizon. However, we don’t think this rebound in yields will coincide with a significant re-steepening of the US Treasury curve. For context, the 2/10 US Treasury slope peaked at 159 bps near the end of March. It is currently 51 bps lower, at 108 bps. We can categorize periods of yield curve steepening as falling into two categories. Bull-steepening: The curve steepens as yields fall. This tends to occur when the Fed is cutting interest rates. Bear-steepening: The curve steepens as yields rise. We can identify these periods as being when the 5-year/5-year forward Treasury yield rises from low levels toward its fair value range. Since 2012, we can identify a fair value range for the 5-year/5-year forward US Treasury yield using survey estimates of the long-run neutral fed funds rate. At present, the fair value range from the New York Fed’s Survey of Primary Dealers is from 2.06% to 2.50%, with a median of 2.31%. The fair value range from the New York Fed’s Survey of Market Participants is from 1.75% to 2.50%, with a median of 2.00%. The 5-year/5-year forward US Treasury yield is currently 1.93% (Chart 7). We identify seven significant periods of 2/10 Treasury curve steepening since 2009 (Table 1). Six of those episodes were bear-steepening episodes that coincided with an increase in the 5-year/5-year yield, the other was a bull-steepening episode that coincided with Fed rate cuts in 2019/20. If we assume that our fair value ranges provide a reasonable target for how high the 5-year/5-year forward US Treasury yield can rise during the next bear-steepening move, it means that – at most – we could see an increase of 57 bps in the 5-year/5-year yield as it moves all the way up to the 2.50% top-end of our target ranges. A linear regression of changes in the 2/10 slope versus changes in the 5-year/5-year forward yield during the six bear-steepening episodes we identified suggests that a 57 bps increase in the 5-year/5-year yield would lead to 12 bps of 2/10 curve steepening (Chart 8). In fact, we can see in both Table 1 and Chart 8 that it would take about 100 bps of upside in the 5-year/5-year yield to bring the 2/10 slope back to its March highs. This is extremely unlikely. Table 1Periods Of US Treasury Curve Steepening In The Zero-Lower-Bound Era A Bump On The Road To Recovery A Bump On The Road To Recovery Chart 8Bear-Steepening Episodes Since 2009 A Bump On The Road To Recovery A Bump On The Road To Recovery   In fact, if the 5-year/5-year forward Treasury yield only rises back to the middle of its fair value range – somewhere between 2% and 2.31% - then our regression suggests that the yield curve slope will probably stay close to its current level. The bottom line is that while investors should position for a rebound in bond yields by keeping portfolio duration low, they should avoid US Treasury curve steepeners. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. The ECB’s New Guidance Solidifies The Defensive Nature Of European Bonds Last week, the European Central Bank (ECB) revised its forward rate guidance in light of its recently concluded Strategy Review.2 The ECB’s new rate guidance is as follows: In support of its symmetric two per cent inflation target and in line with its monetary policy strategy, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target.3   This may sound familiar, and it should. Though not explicitly an Average Inflation Target, the ECB has moved a long way toward the Federal Reserve’s new dovish reaction function. Specifically, both the ECB and Federal Reserve now acknowledge that a temporary period of above-2% inflation will be tolerated, if not explicitly sought. Also, both central banks have linked the timing of the first rate increase to some form of outcome-based forward guidance. The Federal Reserve has explicitly said that it will not lift rates until inflation is above 2% and the economy has reached “maximum employment”. The ECB now claims that interest rates won’t rise until inflation is seen reaching 2% “well ahead of its projection horizon”, a criterion that Christine Lagarde described as having an element of outcome-based guidance.4 The ECB’s new forward guidance may not be as explicitly dovish as the Fed’s. The ECB has no “maximum employment” target and its inflation trigger for lifting rates still relies on the Governing Council’s forecasts. But for investors, the big signal is that the ECB has recognized that the risk of tightening policy prematurely is greater than the risk of remaining on hold for too long. This gives us even more confidence that there will be no ECB tightening on the horizon, and we should continue to view European bond markets as being highly defensive. This is hardly news. European bond markets performed relatively well during the bearish bond episode that lasted from August 2020 to March 2021, they have then gained less than cyclical bond markets (like US and Canada) since March (Table 2). The ECB’s new reaction function ensures that this relationship will remain place for many years to come. Table 27-10 Year Government Bond Returns (In USD, %) A Bump On The Road To Recovery A Bump On The Road To Recovery The new reaction function is also a boon for peripheral European bond markets (like Italy and Spain) where yields trade at a spread above German bunds. The ECB’s commitment to staying dovish will only reinforce the downward pressure on peripheral European bond spreads versus Germany (Chart 9). Chart 9Grab The Extra Spread In Spanish And Italian Bonds Grab The Extra Spread In Spanish And Italian Bonds Grab The Extra Spread In Spanish And Italian Bonds The bottom line is that investors should continue to overweight European bonds within global fixed income portfolios, with a particular emphasis on peripheral European bond markets like Italy and Spain. The defensive nature of European bonds will protect investors from losses during the next move higher in global yields. Italian and Spanish bond markets may not perform quite as well during the next bond bear market as they did between August 2020 and March 2021, as spreads have already compressed a lot. But ultra-accommodative ECB policy will limit the amount of spread widening that can occur, making any additional spread worth grabbing.  Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021 and Global Fixed Income Strategy Weekly Report, “The Message From Falling US Bond Yields”, dated July 21, 2021. 2 The results of the Strategy Review itself are discussed in Global Fixed Income Strategy Weekly Report, “The Reflationary Backdrop Is Still In Place”, dated July 14, 2021. 3 https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.mp210722~48dc3b436b.en.html 4 https://www.ecb.europa.eu/press/pressconf/2021/html/ecb.is210722~13e7f5e795.en.html Recommended Portfolio Specification Other Recommendations A Bump On The Road To Recovery A Bump On The Road To Recovery Treasury Index Returns A Bump On The Road To Recovery A Bump On The Road To Recovery Spread Product Returns A Bump On The Road To Recovery A Bump On The Road To Recovery

Highlights The decline in US Treasury yields has once again reduced the appeal of US paper, relative to foreign developed and emerging market bonds. Historically, lower US bond yields relative to other markets has been dollar bearish. The caveat is that if declining yields are due to a flight to safety, the dollar initially benefits due to US bond inflows. The academic research on which yields matter for currencies is mixed. Historically, short rates have mattered more. But with short-term interest rates anchored at zero, there is evidence investors are moving out the curve. Our bias is that looking across the yield curve will provide a more accurate picture of the countries that will benefit from bond inflows. More importantly, it is the sum of portfolio flows that drive a currency. This means equity flows will be important as well. Feature Global bond yields have rolled over, driven by the long end of the curve. The US 10-year yield has fallen from a high of 1.74% at the end of March to 1.29% today. While other bond yields have rolled over, the move has been more pronounced in the US. For example, the spread between the US 10-year Treasury and the 10-year German bund has narrowed from 200bps to 175bps. Given the correlation between relative interest rates – especially in real terms – and the dollar, a rare divergence has opened up in favor of short dollar positions (Chart I-1). A fall in yields can be driven by prospects of either slowing growth, lower inflation expectations, or a combination of the two. In the case of the US and to a certain extent the eurozone, the culprit behind lower yields has been a drop in both the real and the nominal component. This suggests that the markets are worried about central banks becoming too hawkish at the exact moment global growth is set to slow. Across maturities, the US yield curve has thus flattened (Chart I-2). Chart I-1Real Yields And Currencies Have Diverged Real Yields And Currencies Have Diverged Real Yields And Currencies Have Diverged Chart I-2Flattening Yield Curves Flattening Yield Curves Flattening Yield Curves A few questions arise from the setup above. How do you trade the dollar in the current environment? What is the future path for yields, especially relative yields? Should investors focus on a specific maturity as a signal for future currency moves? Finally, are yields the key driver of currencies in the current environment or should investors focus on other factors as well? Explaining Recent Dollar Strength Chart I-3Rising Demand For Hedges Rising Demand For Hedges Rising Demand For Hedges If the decline in rates globally has been led by the US, then why has the dollar remained strong? The first reason is rising safe-haven demand, especially as global growth peaks. Usually, as a counter-cyclical currency, the dollar benefits in a risk-off environment. The latest Treasury International Capital (TIC) data show that foreign inflows into US bonds have been part of the reason for the decline in Treasury yields since March. A reset in equity markets has also been a driver. The DXY index has been very closely correlated with the put-call ratio in the US, and increased demand for hedges, including long dollar positions, have benefited the greenback (Chart I-3). This has been consistent with the outperformance of the more defensive US equity market. The third reason has been a slowdown in relative economic momentum between the G10 and the US. Chart I-4 shows that the Citigroup economic surprise index for the euro area relative to the US remains strong but has rolled over. The story is similar using relative PMIs between the US and the rest of the G10. Relative economic performance has usually tended to dictate currency movements in the near term. Chart I-4Relative Economic Momentum Is Slowing Relative Economic Momentum Is Slowing Relative Economic Momentum Is Slowing Finally, as we highlighted a fortnight ago, the dollar was oversold and due for a tactical bounce. Leveraged funds have been covering their short positions in recent weeks, while speculators are now long the dollar (Chart I-5). Chart I-5Speculators Are Now Long The Dollar Speculators Are Now Long The Dollar Speculators Are Now Long The Dollar Going forward, most of these trends should reverse. While the Delta variant of COVID-19 is raging across countries, hospitalizations are low, and thus the case for renewed lockdowns is weak. Meanwhile, non-US growth should regain the upper hand, especially in countries like Japan where vaccinations are ramping up quite fast. Global yields should also rise, as output gaps close and inflation remains well anchored.             The Dollar And Interest Rates: Real Versus Nominal? As Chart 1 highlights, it is important to think about relative rates when looking for the next move in the dollar. The historical evidence is that there is little correlation between the dollar and the absolute level or direction of bond yields. Over the last few decades, global bond yields have collapsed while the dollar has undergone rolling bull and bear markets. Currencies react more to the path of relative real rates than nominal rates. By definition, a currency is the mechanism by which prices are equalized across borders. Rising inflation lowers the purchasing power of a currency, which in turn forces the currency to adjust lower in a globally competitive pricing system. Across the G10, there has been a longstanding relationship between real interest rate differentials and the path of the currency (Chart I-6). Chart I-6Negative Real Rates In The US Across The Curve Negative Real Rates In The US Across The Curve Negative Real Rates In The US Across The Curve Chart I-7The US Sports A Very Negative ##br##Real Yield Which Rates Matter For Currencies? Which Rates Matter For Currencies? Importantly, US real rates, especially at the short end of the curve, are very depressed. In fact, compared to other G10 countries, the US sports one of the worst 2-year real yields (Chart I-7). Based on the historical precedent illustrated in Chart I-6, a significant increase in US real rates is required to allow the dollar to rise on a structural basis. What About Hedged Yields? It is true that hedged yields in the US are positive for foreign investors. For example, hedged 10-year US yields for German bond investors provide 97 bps of pickup. For a Japanese investor, the yield pickup in the US is 96 bps, and for a British investor, it is 73 bps (Chart I-8A, Chart I-8B, Chart I-8C). Chart I-8BUS Hedged Yields For Japanese Investors US Hedged Yields For Japanese Investors US Hedged Yields For Japanese Investors Chart I-8AUS Hedged Yields For Euro Investors US Hedged Yields For Euro Investors US Hedged Yields For Euro Investors Chart I-8CUS Hedged Yields For British Investors US Hedged Yields For British Investors US Hedged Yields For British Investors   However, there is little correlation between the hedged yields and currency performance, and for good reason: Under covered interest rate parity, a hedged yield will be an arbitrage opportunity, which should be duly uncovered by efficient markets. This arbitrage window for hedged yields disappears if you extend the maturity of your hedging, as economic theory suggests. For example, hedging a 10-year bond with a 3-month currency forward can lead to massive losses as you roll over these contracts. This is because the cost of hedging in the short term tends to have wild fluctuations. For example, hedging in euros for a German investor buying Treasurys was over 300bps at the end of 2018. This wiped out the positive spread between the two bonds.  Many investors do not hedge currency exposure. In fact, the “least regrets” approach of hedging 50% of currency exposure has been quite popular.1 Therefore, focusing on the real yield, rather than the hedged or nominal yield (Chart I-9), has been a far more robust solution in gauging the direction of currencies. By definition, a hedged yield means buying a currency at spot and selling it forward. This should be currency neutral, and especially, arbitrage away the yield differential. Chart I-9Hedged Yields And Currencies: No Correlation Hedged Yields And Currencies: No Correlation Hedged Yields And Currencies: No Correlation Which Bond Yields Matter? The academic evidence suggests that short-term interest rates matter more for currencies, especially when policy is close to the zero bound. According to a BIS paper,2  not only has the FX impact of monetary policy grown significantly in the last few years, but short maturity bonds have had the strongest impact. Moreover, at a lower level of interest rates, the foreign-exchange impact is greater as the adjustment burden falls onto the exchange rate. Looking purely through the lens of the US dollar, our view is more nuanced. Foreign inflows into US long-term Treasurys have been improving tremendously, while flows into T-bills are relapsing (Chart I-10). This suggests longer-term rates have been a bigger driver of inflows into the US, and, more recently, the dollar rally. It is similar to what occurred at beginning of the dollar bull market last decade. Admittedly, the picture shifted over time, with shorter term flows becoming increasingly important as the Fed began to hike interest rates. Taking a step back, bond investors tend to span the duration spectrum, with pension funds investing in bonds many years out. As 1-year and 2-year yield differentials are not meaningfully different across countries (Chart I-11), this curtails the appeal of short-term paper. If inflation differentials are considered, it reduces the appeal of US paper even further. Chart I-10Long-Term Versus Short-Term Flows Long-Term Versus Short-Term Flows Long-Term Versus Short-Term Flows Chart I-11Narrow Gap In Short Term Yields Narrow Gap In Short Term Yields Narrow Gap In Short Term Yields Let’s not forget quantitative easing. If a central bank explicitly targets a bond yield near zero, like in Japan or Australia, that makes it difficult for that same yield tenor to generate positive inflows or send a reliable signal about the economy. This suggests a better method is looking at a spectrum of indicators, including yields at various maturities. Charts I-12 plots the yield differentials across maturities and countries. It shows that currencies have been correlated across the relative yield maturity spectrum. As such, we recommend investors monitor both short- and long-term yields in evaluating currency decisions. Chart I-12AYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12BYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12CYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12DYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12EYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12FYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12GYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12HYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities Chart I-12IYield Differentials Across Different Maturities Yield Differentials Across Different Maturities Yield Differentials Across Different Maturities    Other Asset Classes There are multiple drivers of exchange rates. Bond yields are just one of them. Equity and other flows also matter. It is the sum of portfolio flows that drive a currency. In fact, inflows into US equities and agency bonds have been the bigger drivers of the US dollar this year (Chart I-13). Outside the US, the correlation between interest rates and the currency can be very weak. The Canadian dollar is much more correlated with terms of trade than with real interest rate differentials. Rising oil prices attract inflows into Canadian corporate bonds and equities, which are positive for the currency. The key point is that flows tend to gravitate to capital markets with the highest expected returns. As such, monitoring flows other than government bond purchases is important. We expect that yields will be higher on a cyclical horizon. This will be beneficial for cyclical stocks, especially banks. This will also be beneficial for flows into non-US bourses, that have a higher weighting of cyclical stocks..  In short, the US equity market has become very tech heavy. Rising interest rates will hurt higher duration sectors such as technology and health care. At the margin, this hurts the relative performance of US equities (Chart I-14). Given that equity inflows have been a key driver of the US dollar, this will also hurt at the margin Chart I-13Agency Bonds And Equity Purchases Have Driven US Inflows Agency Bonds And Equity Purchases Have Driven US Inflows Agency Bonds And Equity Purchases Have Driven US Inflows Chart I-14US Valuations Benefit From ##br##Lower Rates US Valuations Benefit From Lower Rates US Valuations Benefit From Lower Rates   Concluding Thoughts US real interest rates have deteriorated relative to the rest of the world. As such, it will require a significant rise in US real rates to seriously question a dollar bearish view. Meanwhile, a modest rise in global rates will also be bearish for US stocks compared to non-US bourses. US rates are usually high beta, and so could rise more in an improving growth environment. But relative rates are correlated to relative growth. As such, if non-US growth picks up relative to the US, like the IMF expects, this will provide a modest fillip to non-US yields (Chart I-15). US real rates are also very negative, so the bar to create a genuine dollar rally is very high. Finally, the market still expects the Federal Reserve to lead the hiking cycle. This means that there is still potential for an upside surprise in interest rates outside the US, compared to within (Chart I-16). Chart I-15Relative Bond Yields And Relative Economic Momentum Relative Bond Yields And Relative Economic Momentum Relative Bond Yields And Relative Economic Momentum Chart I-16The Market Is Still Relatively Hawkish On The Fed The Market Is Still Relatively Hawkish On The Fed The Market Is Still Relatively Hawkish On The Fed   Housekeeping Our long Scandinavian basket was triggered at our buy point of a -2% pullback from July 9th levels. As such, we are now short EUR/NOK, USD/NOK, EUR/SEK, and USD/SEK. We were also stopped out of our long silver/short gold position for a small loss. We will be looking to reopen this trade in the coming weeks.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michenaud, S., and  Solnik, B., , “Applying regret theory to investment choices: Currency hedging decisions,” Journal of International Money and Finance 27, 2008, 677-694. 2 Ferrari, Massimo, Kearns, Jonathan and Schrimpf, Andreas, “Monetary policy’s rising FX impact in the era of ultra-low rates,” Bank of International Settlements, April 2017. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was mixed: June retail sales came in better than expected. The control group rose 1.1% month on month, versus a -1.4% decline in May. For July, the University of Michigan survey showed inflation expectations continue to edge higher, but the sentiment of current conditions and expectations was well below consensus. Inflows into US assets reversed in May, with net outflows of $30.2bn. Existing home sales rose by 1.4% month on month in June to 5.9 million units. The US dollar DXY index rose modestly this week. Technically, the dollar is now approaching overbought territory. Our intermediate-term indicator has broken above 60, speculators are now long the dollar and sentiment on the greenback has turned up at a time when real rates remain negative in the US. This suggests much optimism is in the price. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of the eurozone this week was robust: The trade balance came it at €9.4bn for May. Final June CPI was in line with expectations – 1.9% for headline and 0.9% for core. The ECB kept rates unchanged in their July 22 meeting, but added to their framework of forward guidance. The euro fell by 40bps this week. Following Christine Lagarde’s Bloomberg interview last week, the ECB made some policy changes. First, they will allow for an inflation overshoot should this be consistent with longer-term inflation at 2%. They will also likely extend the PEPP beyond the March deadline, so no tapering before then. Finally, interest rates are expected to remain negative as far as the eye can see. This is nudging the euro towards becoming a low-beta currency. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 There was some positive news out of Japan this week: Exports rose 48.6% year on year in June. Imports also expanded at a 32.7% year-on-year pace, signaling rising domestic demand momentum. National CPI for June was in line with expectations. The core measure was at 0.2%. Supermarket sales continued to improve in June. The yen was down 0.3% against the dollar this week. The yen is the most shorted developed-market currency, and our intermediate-term indicator is at bombed-out levels. This is occurring at a time when domestic data is on the mend. This is bullish from a contrarian perspective. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There was some mixed data out of the UK this week: Rightmove house prices rose 5.7% year on year in July. The CBI survey was softer than expected in July. Total orders fell from 19 to 17, while the component of selling prices and business optimism fell 4 and 5 points respectively. The pound fell by 0.5% against the US dollar this week. Momentum on the pound continues to suggest near-term downside. Our intermediate term indicator is still blasting downward, and speculators are cutting their long positions from very aggressive levels. This suggests continued near-term downside in cable. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was scant data out of Australia this week: NAB business confidence for Q2 fell from 19 to 17. The RBA minutes confirmed that the central bank will stay dovish in the near term. The AUD fell by 0.7% this week against the USD, the worst performing G10 currency. COVID-19 will continue to dictate near-term developments in Australia, with the latest lockdowns having slowed economic activity. Speculators have started shorting the AUD on this basis (in addition to the risk of a decline in metal prices). In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: Credit card spending rose 6.3% year on year in June. The performance services index rose from 56.1 to 58.6 in June. The NZD was down 23bps versus the US dollar this week. Last week’s rally in the NZD, following the signal that the RBNZ will end QE this week, is fizzling. From a technical standpoint, speculators are neutral the NZD, but our intermediate-term indicator has not yet bottomed out. We are long CHF/NZD, as a reset in global asset prices could increase currency volatility and benefit the pair. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been robust: June housing starts came in at 282.1K versus expectations of 270K. Foreigners continued to accumulate Canadian securities in June, to the tune of C$20bn. House prices remain on fire. The Teranet/National Bank index rose 16% year on year in June. The Bloomberg Nanos Confidence index held steady at 66.3. The CAD rose by 0.2% this week, performing better than other G10 currencies. The longer-term outlook for the loonie is clearly positive as the BoC will hike interest rates ahead of the Federal Reserve. Near term, USD/CAD could retest the 1.28 level as our intermediate-term indicator continues to work off overbought conditions. Ultimately, we will be selling this pair between 1.28 and 1.30. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Exports fell 3% month on month in June. However, watches continued to sell well, with exports rising 71% year on year. Total sight deposits were unchanged at CHF 712 bn for the week of July 16. The Swiss franc was down 0.2% this week. A rebound in global bond yields is a threat to franc long positions. However, we believe the period of volatility in both economic data and equity markets is not over. As such, the franc will benefit from safe-haven inflows. We are long the CHF/NZD cross on this basis. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Data out of Norway is improving: Industrial confidence came in at 11.3 for Q2, from 8.6 the previous quarter. The NOK was down by 0.5% this week against the dollar. This triggered our limit-buy on Scandinavian currencies at the -2% trigger level we had originally been targeting. As such, we are now short EUR/NOK and USD/NOK. With real yields in Norway much higher than in the US or Europe, portfolio flows should benefit the NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been somewhat mixed: There is a slight upward revision to the Bloomberg economic forecasts. GDP growth is now expected to be 4% year on year in 2021, from a previous estimate of 3.5%. However, CPI was revised down 10bps to 1.7% this year, and 1.4% next year, considering the disappointing CPI print last week. The SEK was down 20bps this week. The SEK remains one of our most potent plays on a global growth recovery. Historically, the SEK has correlated very well with global growth variables and relative economic growth between Sweden and the rest of the world. This week, our limit-buy on Scandinavian currencies was triggered. As such, we are now short EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Client, We will be presenting our quarterly webcast next week, and, as a result, will not be publishing on 29 July 2021.  We will cover our major calls for the quarter and provide a look-ahead.  I look forward to the Q+A, and am hopeful you will tune in. Bob Ryan Chief Commodity & Energy Strategist   Highlights Chart Of The WeekOPEC 2.0's Hand Strengthened By Production Agreement OPEC 2.0s Hand Strengthened By Production Agreement OPEC 2.0s Hand Strengthened By Production Agreement The deal crafted by OPEC 2.0 over the weekend to add 400k b/d of oil every month from August preserves the coalition, and sends a credible signal of its ability to raise output after its 5.8mm b/d of spare capacity is returned to market next year.1 KSA and Russia will remain primi inter pares, but the position of OPEC 2.0's core producers – not just the UAE, which negotiated an immediate baseline increase – was enhanced for future negotiations. This deal explicitly recognizes they are the only ones capable of increasing output over an extended period. We assume the revised production baselines for core OPEC 2.0 effective May 2022 reflect the coalition's demand expectations from 2H22 onward. Our modeling indicates core OPEC 2.0's output will almost converge on the revised baseline production of 34.3mm b/d by 2H23, when we expect these producers to be at ~ 33.4mm b/d. Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. We expect Brent to average $70/bbl in 2H21, with 2022 and 2023 averaging $74 and $80/bbl (Chart of the Week). Feature The deal concluded by OPEC 2.0 over the weekend will do more than add 400k b/d of spare capacity to the market every month beginning next month. It also does more than preserve the producer coalition's successful production-management strategy.  The big take-away from the deal is the clear message being sent by the coalition's core members – KSA, Russia, Iraq, UAE and Kuwait – that they are able to significantly increase output after their 5.8mm b/d of spare capacity has been returned to the market over the next year or so. It does so by raising the baselines of the core producers starting in May 2022, clearly indicating the capacity and willingness to raise output and keep it there (Table 1). Table 1Baseline Increases For Core OPEC 2.0 OPEC 2.0's Forward Guidance In New Baselines OPEC 2.0's Forward Guidance In New Baselines What OPEC 2.0's Deal Signals Internally, the deal is meant to recognize the investment made by the UAE in particular, which was not being accounted for in its current baseline. Externally – i.e., to competitors outside the coalition – the deal signals OPEC 2.0's successful production management strategy will continue, by raising the likelihood the coalition will remain intact. This has kept the level of supply below demand over the course of the COVID-19 pandemic (Chart 2), and is responsible for the global decline in inventories (Chart 3). Chart 2OPEC 2.0 Durability Increases OPEC 2.0 Durability Increases OPEC 2.0 Durability Increases Chart 3Inventories Will Remain Under Control Inventories Will Remain Under Control Inventories Will Remain Under Control Specifically, the massive spare capacity still to be returned to the market between now and 2H22 can be accomplished with minimal risk of a market-share war breaking out among the core OPEC 2.0 members seeking to monetize their off-the-market production before the other members of the coalition. Most importantly, the revised benchmark production levels that becomes effective May 2022 signal the coalition members with the capacity to increase production can do so. Longer-Term Forward Guidance We assume the revised production baselines for core OPEC 2.0 effective May 2022 reflect the coalition's demand expectations from 2H22 onward. Our modeling indicates core OPEC 2.0's output will approach the revised baseline reference levels of 34.3mm b/d, hitting 33.4mm b/d for crude and liquids output by 2H23 (Table 2).  Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 OPEC 2.0's Forward Guidance In New Baselines OPEC 2.0's Forward Guidance In New Baselines This implies the core group expects to be able to cover production declines within the coalition and to meet demand increases going forward. The estimates are far enough into the future to prepare ahead of time to increase production. Our estimates for core OPEC 2.0 production reflects our assumption the revised baseline levels do reflect demand expectations of the coalition. In estimating the coalition's production, we rely on historical data from the US EIA, which allows us to estimate future production using regressors we consider reliable (e.g., GDP estimates from the IMF and World Bank).  Non-OPEC 2.0 Production We use EIA historical data for non-OPEC 2.0 production as well. In last week’s balances, we substituted the EIA's estimates for non-OPEC 2.0 producers ex-US for our estimates, which resulted in lower supply numbers throughout our forecast sample.  This threw off our balances estimates in particular, as we did not balance the decrease in supply from this group using the new data set with an increase from another group. We corrected this oversight this week: We will continue to use EIA estimates for non-OPEC 2.0 ex-US countries, but will balance the decrease in oil production from this cohort with increased supply from other countries. Chart 4US Shales Are The Marginal Barrel US Shales Are The Marginal Barrel US Shales Are The Marginal Barrel For US oil production, we will continue to estimate it as a function of WTI price levels, the forward curve and financial variables – chiefly high-yield rates, which serve as a good proxy for borrowing costs for the marginal US shale producer, which we view as the quintessential marginal producer in the global price-taking cohort (Chart 4). Our research indicates US shale producers – like all producers, for that matter – are prioritizing shareholder interests first and foremost. This means they will focus on profitability and margins. While we have observed this tendency for some time, it appears it is gaining speed, as oil and gas producers are now considering whether they want to retain their existing exposure to their hydrocarbon assets.2   There appears to be a reluctance among resource producers generally – this is true in copper, as we have noted – to substantially increase capex. This could be the result of covid uncertainty, demand uncertainty, monetary-policy uncertainty or a real attempt to provide competitive returns. We think it is a combination of all of these, but the picture is clouded by the difficulty in separating all of these uncertainties. Income Drives Oil Demand Chart 5Income Drives Oil Demand Income Drives Oil Demand Income Drives Oil Demand Our demand estimates will continue to be driven by estimates of GDP from the IMF and the World Bank. We have found the level of oil consumption is highly correlated with GDP, particularly for EM states (Chart 5). Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast.  This week, we also will adjust our inventory calculations, which will rely less on EIA estimates of OECD stocks. In the recent past, these estimates played a sizeable role in our forecasts. From this month on, they will play a smaller part. This is why, even though our supply estimates have risen from last week, there is not a significant change to our inventory levels. Investment Implications Holding our demand estimates constant from last week, our revised supply expectations prompt us to move our forecast closer to our June forecast. We expect Brent to average $70/bbl in 2H21, with 2022 and 2023 averaging $74 and $80/bbl. We remain bullish commodities in general, given the continued tightness in these markets. We expect this to persist, as capex remains elusive in oil, gas and metals markets. This underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation.   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 US natural gas exports via pipeline to Mexico averaged just under 7 bcf/d in June, according to the EIA. Exports hit a record high of 7.4 bcf/d on 24 June 2021. The record high for the month was 7.4 Bcf/d on June 24. The EIA attributes the higher exports to increases in industrial and power demand, and high temperatures, which are driving air-conditioning demand south of the US border. Close to 5 bcf/d of the imported gas is used to generate power, according to the EIA. This was up close to 20% y/y. Increases in gas-pipeline infrastructure are allowing more gas to flow to Mexico from the US. Base Metals: Bullish China reportedly will be selling additional copper from its strategic stockpiles later this month, in an effort to cool the market. According to reuters.com, market participants expect China to auction 20k MT of Copper on 29 July 2021. This will bring total sales via auction to 50k MT, as the government earlier this month sold 30k MT at $10,500/MT (~ $4.76/lb). Prior to and since that first auction, copper has been trading on either side of $4.30/lb (Chart 6). Market participants expected a higher volume than the numbers being discussed as we went to press. In addition to auctioning copper, the government reportedly will auction other base metals. Precious Metals: Bullish Interest rates on 10-year inflation-linked bonds remain below -1%, as U.S. CPI inflation rises. US 10-year treasury yields have rebounded since sinking to a five-month low at the beginning of this week. The positive effect of negative real interest rates on gold is being balanced by a rising USD (Chart 7). Safe-haven demand for the greenback is being supported by uncertainty caused by COVID-19’s Delta variant. Gold prices are still volatile after the Fed’s ‘dot shock’ in mid-June.3 This volatility is reducing safe-haven demand for the yellow metal despite rising economic and policy uncertainty. Ags/Softs: Neutral Hot, dry weather is expected over most of the grain-growing regions of the US for the balance of July, which will continue to support prices, according to Farm Futures. Chart 6Copper Prices Going Down Copper Prices Going Down Copper Prices Going Down Chart 7Weaker USD Supports Gold Weaker USD Supports Gold Weaker USD Supports Gold   Footnotes 1Please see 19th "OPEC and non-OPEC Ministerial Meeting concludes" published by OPEC 18 July 2021. 2Please see "BHP said to seek an exit from its petroleum business" published by worldoil.com July 20, 2021.  3Please refer to ‘“Dot Shock” Continues To Roil Gold; Oil…Not So Much’, which we published on  July 1, 2021 for additional discussion. It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Trades Closed OPEC 2.0's Forward Guidance In New Baselines OPEC 2.0's Forward Guidance In New Baselines

Highlights Metals prices are likely to suffer in the short term on the back of weakening Chinese demand and fading inflationary pressures. Accordingly, in our most recent Global Asset Allocation (GAA) Quarterly Outlook, we downgraded the AUD to underweight against the greenback. Bond yields, globally, are bound to rise moderately over the course of the coming 12 months. Australian yields, however, are likely to rise slower than those in the US. The RBA has been explicit in communicating what it would take to adjust its policy stance and is likely to lag behind other central banks in DM. We therefore recommend investors favor Australian government bonds in a global bond portfolio. Australian equities, now dominated by Financials rather than the Materials sector, would benefit from a rise in bond yields. However, a weaker AUD and declining metal prices warrant no more than a benchmark exposure to Australian equities within a global equity portfolio. Introduction Recently, clients have often been asking about Australia. The reasons seem clear. With a potential commodities “super-cycle” driven by a shift to renewable energy and electric vehicles (EVs), both the Australian economy and equities should be in a position to benefit. The reality, however, has been much less positive. Particularly the divergence between the core driver of the Australian market, industrial metals, and the performance of both equities and the currency over the past few years has been a concern (Chart 1). Over the past year and a half, Australian equities have underperformed the MSCI ACWI by 12.4% (Chart 2, panel 1). This underperformance was mainly due to the outperformance of the US. However, even against global markets excluding the US, Australian equities did not match the rise in commodity prices – particularly industrial metals (Chart 2, panel 2). Chart 1Despite The Rise In Metals Prices... Despite The Rise In Metals Prices... Despite The Rise In Metals Prices... Chart 2...Australian Equities Have Not Outperformed ...Australian Equities Have Not Outperformed ...Australian Equities Have Not Outperformed   Chart 3Financials Dominate Australian Equities Financials Dominate Australian Equities Financials Dominate Australian Equities The structure of the Australian market has changed over the past few years. The commodities boom and subsequent global liquidity boom over the past two decades have fueled a housing bubble in Australia and an unsustainable rise in household debt. As a result, Australian equities are no longer dominated by metals and mining stocks, but rather by banks (Chart 3). We structured this Special Report in a Q&A format, answering questions we think are most relevant for investors to assess both the short- and long-term outlook for Australia. We aim to provide an overview of the economy and draw some conclusions on how investors should be positioned. Our conclusions are as follows: Over the past year and a half, the Australian economy has shown how complementary actions between fiscal and monetary policy, as well as social restriction measures, can mitigate both economic and human damage. The Reserve Bank of Australia (RBA) will be in no rush to adjust its policy stance until wage growth is back to its 3% target. However, RBA officials risk running the economy hot in the meantime given that measures of employment are back to their pre-pandemic levels. The RBA is not likely to change its policy stance before reaching its wage growth and inflation targets and will probably lag behind other global central banks in tightening. In that case, investors should favor Australian government bonds in a global bond portfolio. Australian banks remain well-funded and in good health. But their excessive exposure to the housing sector puts them at grave risk if home prices collapse. Despite this, there seems to be a feedback loop where a decline in mortgage rates fuels further demand for loans, pushing up home prices. A slowdown in Chinese credit growth and economic activity will hamper commodity demand, weighing down on Australian equities. The longer-term outlook remains compelling for Australian equities and metals as we enter into a new commodities “supercycle” fueled by a transition to renewable and alternative energy. The Australian economy stands to benefit given that the country has high levels of both production and reserves of the minerals needed for this transition.   Q: How Does The Economy Look In The Short-Term? A: Australia can be regarded as one of the few countries that successfully navigated the pandemic with a minimal amount of damage, both to its population and economy. With swift measures to limit travel and implement social restrictions, the spread of the outbreak was curtailed to slightly over 30,000 total cases, representing only 0.12% of its population (Chart 4). On the other hand, its vaccination campaign has been much slower (at 38 doses administered per 100 people) than in other DM economies such as the US, UK, France, or Germany with 100, 120, 90, and 102 doses per 100 people, respectively. In the short term, this might not seem particularly damaging to the economy. However, if vaccination rates do not pick up rapidly, Australia’s international travel restrictions (which cannot sustainably be kept in place) will hamper economic growth and become a major drag on the tourism and education sectors (Chart 5, panels 1 & 2). Chart 4Government Policies Contained The Pandemic Outbreak... Government Policies Contained The Pandemic Outbreak... Government Policies Contained The Pandemic Outbreak... Chart 5...At The Expense Of Tourism ...At The Expense Of Tourism ...At The Expense Of Tourism Ample fiscal support – in the form of wage subsidies and business support through the JobKeeper program – mitigated the shortfall in household incomes (Chart 6). This provided a boost to both consumers and businesses with Q1 GDP growth coming in at 1.8% quarter-on-quarter (7.4% annualized). GDP expectations for the remainder of this year and next show a resilient strong momentum for Australian growth and domestic demand (Chart 7). Chart 6Fiscal Stimulus Supported Employment... A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under Chart 7...And Overall Growth ...And Overall Growth ...And Overall Growth Chart 8Labor Market Back To Pre-Pandemic Levels... Labor Market Back To Pre-Pandemic Levels... Labor Market Back To Pre-Pandemic Levels...   The labor market recovery has been an excellent example of how fiscal support and lockdown measures complement each other. Most employment indicators have almost recovered or surpassed their pre-pandemic levels: The unemployment rate stands at 4.90%, compared to 5.13%, the underemployment rate is at 7.44%, compared to 8.60%. The total number of those employed is now above its pre-pandemic level, albeit still below the 2018-2019 growth trend (Chart 8).   Q: When Will The RBA Shift Its Policy Stance? A: The RBA has been explicit in communicating that changes in its policy stance hinge on Australian wage growth rising sustainably towards 3% – a level last reached in Q1 2013. Even with economic activity mostly restored, wage growth remains low at 1.49% (Chart 9). Our belief is that until that occurs, the RBA will probably maintain its accommodative stance. Our global fixed-income strategists, in a recent report, highlighted their belief that the RBA is likely to be less hawkish than markets currently expect – on both tapering and hiking rates. We agree with that assessment. Comments by RBA Governor Lowe earlier last month back our dovish belief: He stated that “The Board is committed to maintaining highly supportive monetary conditions to support a return to full employment in Australia and inflation consistent with the target…This is unlikely to be until 2024 at the earliest”. Market expectations nevertheless remain much more hawkish – pointing to a first rate hike by mid 2022 and almost 70 basis points of hikes by 2024 (Chart 10). Chart 9...However Wage Growth Remains Muted ...However Wage Growth Remains Muted ...However Wage Growth Remains Muted Chart 10Market Expects A Hawkish RBA... Market Expects A Hawkish RBA Market Expects A Hawkish RBA   Chart 11...And Is Already Pricing That Down The Curve ...And Is Already Pricing That Down The Curve ...And Is Already Pricing That Down The Curve Chart 12Inflation Remains Well-Below The RBA's Target Inflation Remains Well-Below The RBA's Target Inflation Remains Well-Below The RBA's Target This means that the RBA will probably risk running the economy hot for a while. With total employment back to its pre-pandemic level and other employment indicators closely behind, inflationary pressures, sooner or later, will begin to mount. Higher growth prospects and inflation risks are being discounted further down the curve (Chart 11). The June CPI print is likely to reflect a transitory short-term base effect and the RBA is mostly going to see through that. In the meantime, we would watch other broad inflation indicators to gauge for price pressures. Broader measures such as the trimmed-mean inflation index or median inflation remain subdued at 1.1% and 1.3%, respectively. The 10-year breakeven rate currently stands at 2.1%, within the RBA’s range of 2%-3%, highlighting the market’s belief that long-term inflation remains well under control (Chart 12). Bottom Line: The RBA is likely to maintain its dovish stance for longer than the market expects. A return to sustainable levels of wage growth and inflation will remain the top objectives and it is unlikely that policy will be reversed before they are achieved. Our global fixed-income strategists laid out a checklist of what would make the RBA turn less dovish. So far, only 1 out of 5 items on their list (the recovery in private-sector demand) signals the need for a more hawkish stance. The remaining items signal no imminent pressure on the RBA to adjust policy (Table 1). The RBA is also wary of the currency appreciating if it took a more hawkish stance ahead of other central banks (e.g., the Fed) and is therefore likely to switch policy only after other central banks do so (Chart 13). Accordingly, investors should favor Australian government bonds within a global bond portfolio. Table 1RBA Checklist A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under Chart 13The RBA Will Be Wary Of A Rising AUD The RBA Will Be Wary Of A Rising AUD The RBA Will Be Wary Of A Rising AUD   Q: Are There Signs Of Improvement In The Banking Sector? A: Headline indicators of the health of the Australian banking sector paint a picture of a well-capitalized, highly funded, and profitable industry. Return on equity (ROE) has averaged 12.1% over the past decade. Capital adequacy and Tier 1 capital ratios stand at 14.5% and 18.2%, respectively – much higher than at the start of the Global Financial Crisis (GFC). The ratio of non-performing loans remains low and Australian banks’ reliance on leverage has also decreased (Chart 14). Chart 14Banks Look Healthy... Banks Look Healthy... Banks Look Healthy... Chart 15...But Remain Exposed To The Housing Sector... ...But Remain Exposed To The Housing Sector ...But Remain Exposed To The Housing Sector However, these indicators mask a major underlying risk. Banks remain heavily exposed to the housing market, with housing loans as high as 62% of banks’ gross outstanding loans and 40% of total assets (Chart 15, panel 1). Over the past decade and a half, banks have lent an average of A$56 of housing-related loans for every A$100 in total loans (Chart 15, panel 2).   Chart 16...Which Is Showing No Signs Of Slowing Down ...Which Is Showing No Signs Of Slowing Down ...Which Is Showing No Signs Of Slowing Down Chart 17Households Remain Heavily Indebted Households Remain Heavily Indebted Households Remain Heavily Indebted With interest rates falling over the past few decades, construction activity has boomed. Consequently, the demand for loans for new homes has been rising, leading home prices higher (Chart 16). This also meant that household debt levels have climbed and currently standing at a staggering 130% of GDP and 180% of disposable income (Chart 17).   So what does this mean for banks’ stock prices? The short answer is that absent a bursting of the bubble in house prices, banks should continue to fare well. Interestingly, the long-standing relationship between bond yields and banks’ relative stock price returns – one that works in other financial-heavy markets such as the euro area – did not hold in Australia, at least until recently. In fact, we find that, historically, Australian banks outperformed the broad market when bond yields were falling. This relationship changed post-GFC, most likely when inflation expectations became unanchored and trended lower – reflecting lower commodity prices (Chart 18). Bottom Line: Rising rates, reflecting better growth prospects and higher long-term inflation, should be a tailwind for bank stocks in the short term. Accommodative monetary policy will spur activity in the property market, propping up bank profits. This, however, puts banks at even greater risk when profitability starts to decline, NPLs rise and regulations tighten further. The latter risk is one we would highlight following RBA deputy governor Guy Debelle’s statement that monetary policy will not be used as a tool to curtail housing prices and that there are other tools to address that issue. Chart 18Rising Yields Will Be A Tailwind For Australian Equities Rising Yields Will Be A Tailwind For Australian Equities Rising Yields Will Be A Tailwind For Australian Equities   Q: How Does Chinese Policy Impact Australian Growth? A: China's role in global supply chains, as both a producer and consumer, has increased dramatically since the early 2000s. China’s demand for commodities generally and industrial metals in particular has grown over the past two decades from an average of 10% of total global demand to 50% for most metals (Chart 19). Australia stood to benefit, redirecting more and more of its metals’ production away from the rest of the world and towards China. For example, during the same period, the share of Australian iron ore exports to China increased fourfold (Chart 20). Chart 19China Is A Major Consumer Of Metals... China Is A Major Consumer Of Metals... China Is A Major Consumer Of Metals... Chart 20...And This Has Benefited Australia Over The Past Two Decades ...And This Has Benefited Australia Over The Past Two Decades ...And This Has Benefited Australia Over The Past Two Decades     However, this dynamic leaves the Australian economy very exposed to the Chinese business cycle – one that is heavily reliant on policymakers’ decisions on how much liquidity to inject into the economy. After strong credit and fiscal support throughout 2020, the Chinese authorities – wary of excessive leverage in the economy – have begun paring back stimulus which is likely to lead to weaker growth in the second half of the year and put downward pressure on metal demand (Chart 21). Chart 21Weakening Chinese Demand Will Hurt Metals In The Short-Term Weakening Chinese Demand Will Hurt Metals In The Short-Term Weakening Chinese Demand Will Hurt Metals In The Short-Term Heightened political tensions between Australia and China have also played a role. China recently imposed restrictions, including additional tariffs and bans, on Australian imports such as beef, wine, coal, and other goods. Consequently, Australian exports to China slowed. However, the goods not imported by China were absorbed by other economies – Australian export growth did not fall that much. It is unlikely that a new commodity-heavy marginal buyer will emerge in the short-term to replace Chinese demand. The recent rise in commodity prices reflected a return to economic activity, as well as inflationary fears, and supply, shipping, and logistical backlogs. These will ease in the short term, weighing on both the AUD and Australian equities.   Q: Can The Shift To Renewable Energy Spur Future Australian Growth? A: The shift to renewable energy and electrification – particularly in the transport sector – will occur sooner rather than later. Some commodity-exporting countries stand to benefit, and Australia is likely to be one. We previously highlighted that modeling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency and recycling rates, and the rate of conversion to renewables. Chart 22The Shift To Renewables Will Require More Resources... A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under The mechanics of the future demand/supply relationship hinge on the following: Demand will rise during this energy transition period – simply due to the fact that the new clean energy systems require more minerals (such as copper and zinc) than the current traditional hydrocarbon-fueled energy system (Chart 22, panel 1). Electric vehicles (EVs) require about four and a half times more of certain commodities – particularly copper, nickel, and graphite – than conventional vehicles do (Chart 22, panel 2). Supply limitations, on the other hand, are what might propel metal prices even higher and lead the world economy into a new commodities “supercycle”. A study by the Institute for Sustainable Futures has shown that, in the most positive energy transition scenarios, demand for some metals will exceed supply, in terms of both available resources and reserves (Table 2). Table 2...Which Are Likely To Be In Short Supply A Deeper Dive Into The Land Down Under A Deeper Dive Into The Land Down Under For some of those metals, Australia is either among the top producers, or has the largest reserves. For example, Australia produces almost 45% and 12% of the world’s lithium and zinc, and has 22% and 27% of the world’s reserves. Looking at other metals, supply disruptions – particularly in economies where political, social, and environmental influences are an issue – might be the driver of further price rises. For example, Chile has the largest shares of global lithium reserves (~44%), and copper reserves (~23%), while South Africa has the largest share of global manganese reserves (~40%). Bottom Line: The transition to renewable energy is already underway and is likely to intensify. Forecast demand should outstrip supply and Australia stands to benefit given its large share of current production and/or reserves. How much will depend on the pace of renewable energy integration but miners are likely to be long-term winners.   Q: What Is The Outlook For The AUD? A: The Global Asset Allocation (GAA) service, in its latest Quarterly Outlook, turned negative on the AUD. The currency has historically had a high positive correlation with commodity prices and industrial metals prices, which in turn are very sensitive to Chinese demand (Chart 23). Given our outlook for metals in the short term (falling demand driven by slowing Chinese activity), we expect some weakening in the AUD over the coming 9-to-12 months (Chart 24). Chart 23The AUD Is Highly Correlated To Metal Prices... The AUD Is Highly Correlated To Metal Prices... The AUD Is Highly Correlated To Metal Prices... Chart 24...Which In Turn Are Highly Correlated To Chinese Activity ...Which In Turn Are Highly Correlated To Chinese Activity ...Which In Turn Are Highly Correlated To Chinese Activity Additionally, short-term weakness in the economy, caused by further lockdowns as Delta-variant COVID cases rise, is a risk since it might reduce domestic demand. From a valuation perspective, the AUD is slightly below its fair value (Chart 25). However, this on its own does not compel us to remain positive on the currency. We also consider other indicators such as investor positioning – which has reached a decade high, according to Citibank’s FX Positioning Alert Indicator (PAIN) (Chart 26). This indicator suggests that active FX traders hold substantial long positions in the AUD against the USD. Historically, this indicator has provided contrarian signals, with extreme optimism (pessimism) providing useful short (long) signals. Chart 25The AUD Is Close To Fair Value The AUD Is Close To Fair Value The AUD Is Close To Fair Value Chart 26Investors Are Long The AUD Investors Are Long The AUD Investors Are Long The AUD Bottom Line: Short-term weakness in the economy and a reversal in metal prices warrant caution on the currency. While valuations do not signal overbought conditions, investor positioning (a contrarian indicator) does.   Q: How Should Equity Investors Be Positioned? A: Our recent Special Report on whether country or sector effects drive equity performance showed that sector composition was relatively important in Australia, given the large difference in sector weightings relative to the global benchmark. Our analysis showed that cumulative Australian sector performance over the past two decades detracted from overall returns (Chart 27). Given that framework, and the relationship between the Australian economy and industrial metals, we find that Australian equity performance relative to the US mirrors the performance of global metal and mining relative to global tech stocks (Chart 28). This underperformance makes sense: Commodity prices have been in a structural downtrend throughout the past decade. Chart 27Country Vs Sector Effect Country Vs Sector Effect Country Vs Sector Effect Chart 28Australia / US = Metals / Tech Australia / US = Metals / Tech Australia / US = Metals / Tech Therefore, given our view of the outlook for metals, we would not want to shun Australian equities. The Global Asset Allocation (GAA) service is currently neutral the Australian market within a global equity portfolio, and underweight the Materials sector over the next 12 months. We believe this positioning makes sense given the slowdown in the Chinese economy and the improbability that another country will emerge as the alternative marginal buyer of commodities. The longer-term outlook is more compelling however, as the shift to decarbonization, renewables, and alternative energy gets underway. Conclusions In the short term metals prices are likely to suffer on the back of weakening Chinese demand (with no immediate substitute as a marginal buyer) as well as fading inflationary fears and an easing of supply/logistical issues. Our analysis shows that sector composition is a larger driver of Australian equity relative performance than country composition. While Australian equities – dominated by Financials – would benefit from a moderate rise in global bond yields, yields will rise more slowly in Australia than in the US and the AUD is likely to weaken. Over the next 12 months, investors should remain neutral on Australian equities within a global equity portfolio. The RBA is likely to lag other central banks in tightening policy. Investors should therefore favor Australian government bonds over other developed economies such as the US and Canada.   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com