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Dear Client, I will be holding a webcast next Friday, September 24th at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT) with BCA Research’s Chief Emerging Markets Strategist Arthur Budaghyan where we will debate the outlook for EM stocks. As this week’s report conveys, I am bullish, while Arthur is in the bearish camp. Please join us for what is sure to be a fiery debate. Also, instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the stability of the American political system. I hope you will find it insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2021 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, October 7th. Best regards, Peter Berezin Chief Global Strategist Highlights After lagging the global indices, EM stocks are set to outperform during the remainder of this year and into 2022. Go long the EM FTSE index versus the global benchmark (ETF proxy: VWO versus VT). Five factors will support EM assets over the coming months: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Investors wanting to gain exposure to Chinese tech while still limiting risk should consider writing cash-covered puts. For example, a strategy of selling puts on Alibaba could generate a 9% annualized yield while giving investors access to the stock at a forward PE ratio of only 12.5. Go long an equally-weighted basket consisting of the Russian ruble and Brazilian real against the US dollar. Both currencies enjoy favorable interest rate differentials and will benefit from continued strength in commodity markets. Debating The EM Outlook BCA Research has some of the brightest, most creative strategists in the world. While we often agree on many issues, we sometimes disagree. The near-term outlook for emerging markets is a case in point. My colleague, Chief EM Strategist Arthur Budaghyan, is bearish on emerging markets over a 3-to-6 month horizon. In contrast, I am bullish. In this note, I explain why. I see five reasons why EM assets will do very well during the remainder of the year and into 2022: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Let’s examine all five reasons in turn. Vaccine Access In Emerging Markets Is Improving The proportion of EM populations which have been vaccinated is rising rapidly (Chart 1). India is now vaccinating 10 million people per day, a number that would have seemed unimaginable just a few months ago. Chart 1EM Vaccination Rates Have Been Ramping Up Rapidly Globally, about 10 billion doses of vaccine will be produced this year (Chart 2). This does not include potential new mRNA vaccines that China is developing. China-based Walvax Biotechnology is conducting late-stage trials in Nepal, with mass production of the vaccine expected to start in October. Sinopharm is also working on its own mRNA vaccine. Meanwhile, the number of new Covid cases in most EM economies has peaked, permitting a relaxation of lockdown measures (Chart 3). Goldman’s Effective Lockdown Index for China has eased significantly since mid-August, although this week’s outbreak in Fujian province could partially reverse that trend. Chart 2At Least 10 Billion Doses Of Vaccine Will Be Produced This Year Chart 3EM Lockdown Measures Have Eased As The Number Of New Cases Has Peaked It is true, as Arthur has pointed out, that vaccine hesitancy is a problem in some emerging markets. However, this may not be as significant an issue as previously believed. The huge spike in cases in highly vaccinated countries such as Israel and the UK shows that herd immunity is a pipe dream. Given this reality, as long as everyone who wants a vaccine is able to receive it, the political pressure to maintain lockdowns will dissipate. Pandemic-Induced Spike In Inflation Is Fading As in most developed economies, many emerging markets have experienced a post-pandemic rise in inflation (Chart 4). Whereas DM central banks generally looked through the inflation spike, many EMs did not have that luxury. Chart 4Inflation Across The EM Universe   Worried about an unmooring of inflation expectations and currency depreciation, central banks in such countries as Brazil, Mexico, Chile, Colombia, Peru, Russia, and Turkey have all raised rates this year. Higher rates have weighed on EM growth and financial markets. The good news is that inflationary pressures are starting to abate. This week’s US CPI report for August showed an absolute decline in prices in pandemic-related categories such as airfares, hotels, admissions, and vehicles (Chart 5). Things are even improving on the semiconductor front. Chart 6 shows that memory chip prices are in a clear downtrend. Chart 5Pandemic-Driven Inflation Is Cresting Chart 6Chip Prices Are Off Their Highs Chart 7Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Critically for emerging markets, agricultural prices have stabilized (Chart 7). Historically, food inflation has been a major driver of EM inflation. Chinese Stimulus On The Way Growth in China was quite weak in the first half of the year, averaging only 3.5% on a sequential annualized basis (Chart 8). The Bloomberg consensus estimate is for Q3 growth to hit 4.3%, reflecting the negative impact of lockdown measures and the lagged effect from policy tightening. Growth in the fourth quarter is expected to rebound to only 5.7%. This seems too low to us. Barring a major spike in Covid cases, Chinese industry will be saddled with fewer social distancing restrictions in the fourth quarter. Policy is also turning more stimulative. The PBOC cut bank reserve requirements in July. In the past, cuts in reserve requirements have been a reliable predictor of faster credit growth (Chart 9). Chart 8Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chart 9Chinese Stimulus Is On The Way   With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. On the contrary, the PBOC’s meeting with financial institutions on August 23rd revealed a desire to increase credit availability. Partly reflecting this development, new bank loans rose to RMB 1.22 trillion in August, up from RMB 1.08 trillion in the prior month. Chart 10EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed On the fiscal side, the Ministry of Finance stated on August 27th its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. To reinforce the need for more stimulus, the authorities announced an additional RMB 300 billion in credit support for SMEs during the latest State Council meeting held on September 1st. Local Chinese government spending has typically flowed into infrastructure. Increased infrastructure spending should buttress metals prices while providing a tailwind for global industrial stocks. I agree with Arthur’s assessment that industrials will be a winning equity sector over the coming years. EM stocks have usually beaten the global benchmark during periods when global industrial stocks were outperforming (Chart 10).   A Weaker US Dollar Will Benefit Emerging Markets EM stocks tend to perform best when the US dollar is on the back foot (Chart 11). We expect the greenback to weaken over the next 12 months. As a countercyclical currency, the dollar is likely to struggle in an environment of above-trend global growth (Chart 12). Chart 11EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening Chart 12The Dollar Is A Countercyclical Currency Interest rate differentials have moved sharply against the dollar (Chart 13). The US trade deficit has surged over the past 16 months. The way the US has been financing its trade deficit – relying heavily on fickle equity inflows – also leaves the dollar in a vulnerable position (Chart 14). Chart 13Interest Rate Differentials Have Moved Against The Dollar Chart 14Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Go Long BRL And RUB Against a backdrop of broad-based dollar weakness, EM currencies will strengthen. Currently, the 12-month interest rate differential between Brazil and the US stands at 8.7%, up from a low of 2.1% last year. Russian rates have also risen rapidly relative to US rates (Chart 15). The Russian ruble will benefit from the cyclical recovery in oil prices. Bob Ryan and BCA’s commodity team project that the price of Brent will rise 5% to $80/bbl in 2023, whereas market expectations are for a 12% decline (Chart 16). Likewise, Brazil will gain from both higher oil prices and rising Chinese demand for metals. Chart 15Interest Rate Differentials Favor The RUB And BRL Versus The USD Chart 16Oil Prices Have More Upside Accordingly, we are initiating a new trade going long an equally-weighted basket consisting of BRL/USD and RUB/USD. Are EMs A Value Trap? Emerging market stocks currently trade at a Shiller PE ratio of 14.7, compared to 36.8 for the US, 22.2 for Europe, and 24.1 for Japan. The EM discount to the global index is as large now as it was during the late 1990s. Other valuation measures tell a similar story (Chart 17). Chart 17AEM Equities Are Trading At A Large Discount (I) Chart 17BEM Equities Are Trading At A Large Discount (II) A low PE ratio for EM stocks could be justified based on weak expected earnings growth. However, it is far from clear that such an expectation is warranted. While EM earnings growth has lagged the US since 2011, this follows a decade when EM earnings grew much faster than in the US (Chart 18). Chart 18AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) Chart 18BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) Chart 19EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings On that note, it is worth mentioning that US earnings have risen by only 6 percentage points more than EM earnings since mid 2019 (20% versus 14%), even as EM stocks have underperformed their US peers by 29% over this period (52% versus 23%) (Chart 19). China’s Regulatory Crackdown The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 48% since February (Chart 20). Chart 20Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese tech is 44% of the China investable index and 15% of the MSCI EM index. Thus, the outlook for Chinese stocks is relevant not just for China-focused investors, but for EM investors more broadly (especially those who invest in index products). The current crackdown bears some resemblance to the one in 2018, which saw Tencent lose $20 billion in market capitalization in a single day. Like other Chinese tech names, Tencent shares quickly recovered from that incident. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (i.e., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support. A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party just as US companies have pledged allegiance to woke ideology. If that were to happen, the Chinese government may allow them to operate normally, cognizant of the fact that it is easier to monitor a few large internet companies than many small ones. While such an outcome is far from assured, current valuations offer enough cushion to prospective investors. As we go to press, Alibaba is trading at 16.4-times earnings, Baidu is trading at 17.9-times earnings, and Tencent is trading at 26.7-times current year earnings. In comparison, the NASDAQ 100 trades at nearly 30-times earnings. Investment Conclusions Sentiment towards EM stocks is very bearish (Chart 21). Investor angst towards China is especially elevated, with the media replete with stories about the tech crackdown and problems at Evergrande, the country’s largest property developer. Chart 21Sentiment Towards EM Stocks Is Highly Bearish All these downside risks to EM assets are well known. What are less well known are the upside risks stemming from higher vaccination rates, an easing of domestic inflationary pressures, Chinese stimulus, a weaker US dollar, and favorable valuations. With that in mind, we are upgrading our rating on EM equities and currencies to strong overweight in the view matrix at the back of this report. We are also reinstating a long EM/Global equity trade (ETF proxy: VWO versus VT). The risk-reward of buying Chinese internet stocks is reasonably appealing. Investors who want to mitigate risk should consider writing cash-covered puts. For example, a BABA put with a strike price of $130 expiring on December 16th 2022 trades for about $16. If the price of BABA does not fall below $130, you will pocket the premium, realizing an annualized yield of 9%. If the price does fall to $130, you get the stock at an attractive PE ratio of 12.5 based on current forward earnings estimates.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Stocks tend to perform worse when unemployment is low. Since 1950, the S&P 500 has risen at an annualized pace of 12% when the unemployment rate was above its historic average compared to 6% when the unemployment rate was below its average. Three reasons help explain this relationship: 1) The unemployment rate has historically been mean-reverting; 2) Low unemployment often leads to monetary tightening; and 3) Valuations are usually more stretched when unemployment is low. In the spring of 2020, stocks benefited from what turned out to be a very auspicious environment: A steady decline in the unemployment rate from very high levels, assisted by a massive dose of monetary and fiscal stimulus. Today, the situation is less clear-cut. The labor market has improved dramatically, while both monetary and fiscal policy are turning less accommodative. Nevertheless, the Fed is unlikely to hike rates for at least 12 months, and it will take much longer than that for monetary policy to turn restrictive. This suggests that we are still in the middle-to-late stages of a business cycle expansion that began following the Great Recession (and was only briefly interrupted by the pandemic). Historically, cyclical stocks have done well during this phase of the business cycle. To the extent that cyclicals are overrepresented in overseas indices, investors should favor non-US stock markets. Non-US stocks also trade at a substantial valuation discount to their US peers. A Surprising Relationship One of the best pieces of advice I received when I was starting my research career was to get to the punchline as soon as possible. As a strategist, you are not writing a detective novel where the answers are shrouded in mystery until the very end. You are providing conclusions to readers with supporting evidence. Chart 1Stocks Do Best When Unemployment Is High With that in mind, let me answer the question posed in the title of this report: Is low unemployment good or bad for stocks? As Chart 1 shows, the answer is bad. The interesting issues are why it is bad and what this may mean for investors today. There are three key reasons why low unemployment has typically corresponded with paltry equity returns: The unemployment rate has historically been mean-reverting: Low unemployment is often followed by high unemployment. And, when the unemployment rate starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession occurring (Chart 2). Chart 2When Unemployment Starts Rising, It Usually Keeps Rising Low unemployment often leads to monetary tightening: An economy can only grow at an above-trend pace if there is labor market slack. Once the slack runs out, growth is liable to weaken as supply-side constraints kick in. Worse yet, labor market overheating has historically prompted central banks to raise rates (Chart 3). Higher rates in the context of slowing growth is toxic for stocks. Valuations are usually more stretched when unemployment is low: During the post-war period, the S&P 500 has traded at an average Shiller P/E ratio of 22.5 when the unemployment rate was below its historic average compared to 16.3 when the unemployment rate was above its average. Implications For The Present Day Stocks fare best when unemployment is high but falling. In contrast, stocks fare the worst when unemployment is low and rising (Chart 4). My colleague Doug Peta, BCA’s Chief US Investment Strategist, reached a similar conclusion in his August report entitled Level Or Direction? Chart 3Low Unemployment Often Leads To Monetary Tightening Chart 4Stocks Do Best When Unemployment Is Falling From High Levels   In the spring of 2020, stocks benefited from what turned out to be a very auspicious environment: A steady decline in the unemployment rate from very high levels, assisted by a massive dose of monetary and fiscal stimulus. Controversially at the time, this led us to argue that the pandemic could lead to much higher stock prices. Chart 5There Is Still Slack Today, the situation is less clear-cut. On the one hand, the unemployment rate has fallen dramatically, while monetary and fiscal policy are turning less accommodative. This week, the ECB reduced the pace of net asset purchases under the PEPP. The Fed will start paring back asset purchases by the end of this year. Governments are also withdrawing fiscal policy support. In the US, emergency federal unemployment benefits expired, somewhat ironically, on Labor Day. On the other hand, the unemployment rate in most economies is still above pre-pandemic levels. In the US, the unemployment rate for prime-age workers is 1.7 percentage points higher than in February 2020, while the employment-to-population ratio is 2.4 points lower (Chart 5). The presence of labor market slack ensures that policy support will be withdrawn only gradually.   Granted, core CPI inflation in the US is running above 4%. Standard Taylor Rule equations suggest that the Fed funds rate should be well above zero (Chart 6). That said, these equations use realized inflation, which may be misleading given that both market participants and Fed officials expect inflation to fall rapidly (Chart 7). Indeed, the widely followed 5-year/5-year forward TIPS breakeven rate is below the Fed’s comfort zone (Chart 8).1 With long-term inflation expectations still subdued, there is no urgency for the Fed to sound more hawkish. Chart 6What Rate Does The Taylor Rule Prescribe? Chart 7Investors Expect Inflation To Fall Rapidly From Current Levels Chart 8Long-Term Inflation Expectations Are Muted Cyclical Stocks Usually Do Best In The Latter Innings Of The Business Cycle Expansion Monetary policy is unlikely to become restrictive in any major economy during the next 18 months, which should allow global growth to remain at an above-trend pace. Hence, it is too early to turn bearish on stocks. Nevertheless, given that the unemployment rate in most countries is closer to a trough than to a peak, it is reasonable to conclude that we are somewhere in the middle-to-late stages of a business cycle expansion that began following the Great Recession (and was only briefly interrupted by the pandemic). As Chart 9 shows, cyclical equity sectors, such as industrials, energy, and materials, typically do best in the latter innings of business cycle expansions. Such was the environment that prevailed in 2005-08, and such will be the environment that prevails over the coming quarters as the unemployment rate falls further, capital spending increases, and commodity prices rise further. Chart 9The Business Cycle And Equity Sectors Increased government infrastructure spending should help cyclical sectors. The US Congress is set to pass a 10-year $500 billion package. The EU’s €750 billion Next Generation fund is finally up and running. Chinese local government infrastructure spending is poised to accelerate over the remainder of the year.   Chart 10The Dollar Is A Countercyclical Currency Chart 11Past Another Covid Wave A weaker US dollar should also buoy cyclical stocks (Chart 10). As a countercyclical currency, the greenback usually weakens when global growth is strong. A cresting in the Delta variant wave should help jumpstart global growth over the coming months (Chart 11). Meanwhile, interest rate differentials have moved sharply against the US dollar, while the US trade deficit has widened noticeably (Charts 12A & B).   Chart 12AInterest Rate Differentials Have Moved Against The Dollar Chart 12BThe US Trade Deficit Has Widened Noticeably Cyclical sectors are overrepresented outside the US (Table 1). Although not a classically cyclical sector, financials are also overrepresented in overseas indices. BCA’s global fixed-income strategists recommend a moderately underweight duration stance. As bond yields rise, bank shares should outperform (Chart 13). In contrast, tech stocks often lag in a rising yield environment. Table 1Cyclicals Are Overrepresented Outside The US Chart 13Higher Rates: A Boon For Banks And A Bane For Tech How Expensive Are Stocks? A high Shiller P/E predicts low future returns (Chart 14). Today, the Shiller P/E stands at 37 in the US. This is consistent with an expected 10-year total real return of close to zero for the S&P 500. Thus, the long-term outlook for US stocks is poor. We stress the words “long term.” As the bottom panel of Chart 14 shows, no matter what the starting point of valuations is, the average return over short-term horizons is very low relative to realized volatility. This is another way of saying that valuations provide a great deal of information about the long-term outlook for stocks, but little information about their near-term direction. Over horizons of about 12 months, the business cycle drives the stock market, as a simple comparison between purchasing manager indices and stock returns illustrates (Chart 15).   Chart 14Valuation Is The Single Best Predictor Of Long-Term Equity Returns Chart 15AThe Business Cycle Drives Cyclical Swings In Stocks Chart 15BThe Business Cycle Drives Cyclical Swings In Stocks Outside the US, the Shiller P/E stands at 20. In emerging markets, it is only 16 (Chart 16). This is significantly below US levels, implying that the long-term prospect for equities is much more attractive abroad. Thus, both medium-term cyclical factors and long-term valuation considerations favor non-US stocks.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 16US Stocks Are Pricey Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights The equity risk premium has turned negative for the first time since 2002. It follows that any significant rise in bond yields will cause risk-asset prices to collapse, quickly flipping any incipient inflationary shock into a deflationary shock. Shorting bonds yielding 2 percent is a ‘widow maker’ trade, as anybody who has tried this with a long list of government bonds has learned to their cost, the most recent being UK gilts. Hence, the next on the list for the ‘widow maker’ is shorting the US 30-year T-bond which is now yielding 2 percent. In fact, the US 30-year T-bond is a must-own structural investment. Fractal analysis: Medical equipment versus healthcare services. Feature Chart of the WeekThe Equity Risk Premium Turns Negative For The First Time Since 2002 Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. For example, the US 10-year Treasury Inflation Protected Security (TIPS) and the UK 10-year index linked gilt are yielding -1.3 percent and -2.8 percent respectively. Meaning that anybody who buys and holds these bonds to redemption is guaranteed a deeply negative 10-year real return. Meanwhile, in nominal yield space, 10-year government bonds yield -0.35 percent in Germany and Switzerland, 0.7 percent in the UK, and 1.3 percent in the US. What about equities? Unlike a bond’s redemption yield, equities do not offer a guaranteed long-term return for buy-and-hold investors. So, some analysts assume that the equity market’s earnings yield is the proxy for this long-term return. According to these analysts, the US equity market’s earnings yield of 4.4 percent means that it will deliver a prospective long-term real return of 4.4 percent per annum. Compared to the 10-year TIPS real yield of -1.3 percent, they argue that this offers an excess return or ‘equity risk premium’ of a comfortable +5.7 percent. Therefore, claim these analysts, equities are reasonably valued, relative to bonds, and in absolute terms.  But as we will now demonstrate, this analysis is deeply flawed. The Equity Risk Premium Has Turned Negative The equity market’s earnings yield is a valuation metric, so clearly there is some connection between it and the prospective return delivered by the equity market. Nevertheless, the crucial point to grasp is that: The equity market’s earnings yield does not equal its prospective return. Charts I-2 - I-3 should make this point crystal clear. As you can see, the earnings yield rarely equals the delivered prospective 10-year return, either real or nominal. When the earnings yield is elevated, the prospective return turns out higher. Conversely, when the earnings yield is depressed, as now, the prospective return turns out to be much lower. Chart I-2The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... Chart I-3...Or In Nominal ##br##Terms Therefore, to take the current earnings yield of 4.4 percent and subtract the real bond yield of -1.3 percent to derive an equity risk premium of +5.7 percent is analytically flawed, just as it is analytically flawed to subtract apples from oranges. To derive the equity risk premium, the correct approach is first to translate the earnings yield into a prospective 10-year return based on the established mathematical relationship between these variables. Chart I-4 does this and shows that, based on a very tight mathematical relationship through the past thirty five years, an earnings yield of 4.4 percent translates into a prospective 10-year nominal return of just 1 percent. Chart I-4We Must Mathematically Map The Earnings Yield Into A Prospective Return... Having translated the earnings yield into a prospective 10-year nominal return of 1 percent, we can now make an apples-for-apples comparison with the 10-year T-bond yield of 1.3 percent (Chart I-5). Chart I-5...And Only Then Subtract The Bond Yield Derived correctly therefore, the equity risk premium has turned negative for the first time since 2002 (Chart of the Week). We deduce that the equity market is very richly valued both in absolute terms and relative to bonds. And crucially, that this rich valuation is contingent on bond yields remaining ultra-low, or going even lower. Shorting Bonds Yielding 2 Percent Is A ‘Widow Maker’ All of which brings us to one of the most pressing questions we get from clients. When a bond is offering a feeble yield, what is the point in owning it? Maybe the best people to answer are the casualties of the now infamous ‘widow maker’ trades. The original widow maker trade was the idea that the yield on the Japanese Government Bond (JGB), at 2 percent, was so feeble that there was no point in owning it. Furthermore, with massive Japanese fiscal stimulus coming down the pike, the ‘no-brainer’ investment strategy was not just to disown the JGBs, but to take an outright short position, as it seemed that the only direction that JGB yields could go was up. In fact, JGB yields did not go up, they continued to trend down. As feeble yields became even feebler, the owners of the short positions got carried out of their careers, feet first. Meanwhile, those investors who owned 30-year JGBs yielding a ‘feeble’ 2 percent in 2013 reaped returns of 75 percent, and even now, are sitting on handsome profits of 55 percent. Some people protest that Japan is an exceptional and isolated case, rather than a template for economies which will not repeat their putative policy-errors. Such protests have always struck us as factually wrong, blinkered, and even prejudiced. Nevertheless, let’s indulge these prejudices with a simple rejoinder – forget Japan, what about Switzerland, or the UK? (Chart I-6) Chart I-6Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Meanwhile, those investors who owned 30-year UK gilts yielding a ‘feeble’ 2 percent in 2018 reaped returns of 40 percent, and even now are sitting on tidy profits of 30 percent. Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Bear in mind that a 30-year bond yielding a feeble 2 percent will deliver a cumulative return of more than 80 percent to redemption. And that if the feeble yield becomes even feebler, this return will get front-end loaded, creating widow makers for the short positions and spectacular gains for the long positions, as witnessed in JGBs and UK gilts. The 30-Year T-Bond Is A Must-Own Structural Investment The next candidate for the widow maker is shorting the US 30-year T-bond, which is yielding, you guessed it, 2 percent. Remember that while Japan may not be a great template for the US, the UK certainly is – because the US and UK have very similar economic, financial, political, social, and cultural structures. Until recently therefore, bond yields in the US and UK were moving in near-perfect lockstep (Chart I-7). Chart I-7The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock So, what happened? The one word answer is: Brexit. The recent difference between US and UK bond yields is simply that the UK has had one more deflationary shock than the US. Put the other way around, the US is just one deflationary shock away from a UK level of bond yields – meaning the 30-year yield not at 2 percent, but at 1 percent. But why can’t the next shock be an inflationary shock resulting in much higher yields? The simple answer is that the equity risk premium has turned negative for the first time since 2002. Moreover, as we pointed out in The Road To Inflation Ends At Deflation the extremely rich valuation of $300 trillion of global real estate is also highly contingent on ultra-low bond yields. It follows that any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. In a $90 trillion global economy, this will quickly flip any incipient inflationary shock into a deflationary shock. Any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. We conclude that the US 30-year T-bond is a must-own structural investment. Fractal Analysis Update As hospitals have rushed to clear their backlog of non-pandemic treatments and procedures, medical equipment stock prices have surged. This is particularly true for US medical equipment (ticker IHI) which, since June, is up by 25 percent versus US healthcare services (Iqvia, Veeva, or loosely proxied by ticker XHS). Given that the backlog of treatments will eventually clear, and that the intense rally is now extremely fragile on its 65-day fractal structure (Chart I-8), a recommended countertrend trade is to short US medical equipment versus healthcare services. Set the profit target and symmetrical stop-loss at 8.5 percent.  Chart I-8The Intense Rally In Medical Equipment Stocks Has Become Fragile   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights A decline in the marginal propensity to spend out of both income and wealth over the past few decades generated a flood of excess savings. Facing a chronic shortfall of aggregate demand, central banks had no choice but to cut interest rates. This inflated asset prices. Looking out, the marginal propensity to spend should rise as household deleveraging pressures abate, retiring baby boomers shift from being savers to dissavers, and labor’s share of income increases. While rising bond yields will be a headwind to equities, continued above-trend global growth, upward earnings revisions, forthcoming Chinese fiscal stimulus, and a cresting in the number of new Delta variant cases all justify overweighting stocks on a 12-month horizon.  A more cautious stance towards equities will be appropriate in two years’ time once stagflationary forces begin to assert themselves. The Keynesian Cross The “Keynesian Cross” is one of the first diagrams that students encounter in introductory macroeconomic courses (Chart 1). It simply plots Aggregate Expenditure (AE) versus output (Y). Chart 1The Keynesian Cross Aggregate expenditure consists of personal consumption, capital investment, government expenditure, and net exports:   (1)                                                                  If spending exceeds output, inventories will decline, causing firms to raise production. In contrast, if output exceeds spending, inventories will increase, prompting companies to cut production. Hence, the economy gravitates towards a level of output where inventories are stable; that is, where AE is equal to Y. Importantly, this level of production may or may not correspond to full employment. Introducing Asset Prices The Keynesian Cross model does not explicitly include asset prices. However, this can be easily rectified by postulating that spending depends on both income and wealth. For example, let us express consumption as:   (2)                                                                  In this equation, α is the marginal propensity to consume out of wealth (i.e., how much consumption rises for every dollar increase in wealth, W) while β is the marginal propensity to consume out of income, Y.1  An increase in asset prices will boost wealth, leading to more consumption. A Simple But Illuminating Identity Consider the case where inventories are stable. Substituting equation (2) into equation (1) and then dividing by Y yields:   (3)                                                      The equation above is an identity. It does not say that a change in one term must lead to a change in another term in any causal sense of the word. All it says is that the terms on the right-hand side of the equation must add up to one. Suppose, for example, that α or β were to decline. If that were to happen, consumption would fall, leading to lower output. In order to restore output to its original level, either wealth would need to rise or some combination of investment, government spending, and net exports would need to increase. Upward Pressure On Savings There are at least three reasons to think that α and β have declined since the early 1980s: Chart 2US Household Debt Burdens Have Eased Significantly Over The Past Decade Deleveraging: The need for households in economies such as the US to repair their balance sheets in the aftermath of the Global Financial Crisis put upward pressure on desired savings, leading to a decrease in β. The inability to use the equity in one’s home to finance consumption also lowered α. To this day, outstanding home equity line of credit (HELOC) balances in the US are a shadow of their former selves (Chart 2).  Demographics: Savings vary over the life cycle. In general, savings are highest between the ages of 35 and 60 (Chart 3). The percentage of households in developed economies in their peak savings years began to increase in the late 1970s. While the trend has reversed in recent years, the ratio of workers-to-consumers in most countries (the so-called “support ratio”) remains elevated (Chart 4). Inequality: Higher income households save a greater share of their incomes than lower income households. As Atif Mian, Ludwig Straub, and Amir Sufi documented at last week’s Jackson Hole symposium, the rise in income inequality since 1980 has pushed up desired savings, thus lowering β in the process (Chart 5). Likewise, there is evidence that wealthier households tend to spend less of every additional dollar of wealth than poorer households.2 To the extent that wealth inequality has also increased since 1980, α has declined.   Chart 3ASavings Peak Around Middle Age (I) Chart 3BSavings Peak Around Middle Age (II)   Chart 4AIncreased Desired Savings Corresponded To A Rise In Support Ratios (I) Chart 4BIncreased Desired Savings Corresponded To A Rise In Support Ratios (II)       Chart 5Income Inequality Has Skewed The Composition Of Savings   The Need For Policy Support The decline in α and β over the past few decades could have been offset by an increase in investment or net exports. Unfortunately, at least in the US, that never happened (Chart 6). The US trade deficit in goods and services stood at 3.9% of GDP in Q2 of 2021, the highest in 12 years. The non-petroleum trade deficit is at a record high. Investment spending also remains below the levels reached in the pre-GFC period. The shortfall in aggregate demand put pressure on policymakers to spur the economy. The results were somewhat mixed. Looking at the US, government spending on goods and services rose substantially during the Great Recession. However, spending then proceeded to fall to multi-decade lows as a share of GDP by 2019 (Chart 7). Transfer payments were also broadly stable as a share of GDP in the decade leading up to the pandemic. The Trump tax cuts reduced government revenue by around 1.7% of GDP. However, as we have noted in the past, the impact of the tax cuts on aggregate demand was fairly small. Chart 6US Private Sector Investment Remains Below Its Pre-GFC Peak While The Non-Petroleum Trade Deficit Is At A Record High Chart 7Fiscal Policy Has Been More Reactive Than Proactive In The US After surging during the pandemic, both direct government expenditure and transfer payments have come off their highs. Tax rates are also likely to rise for upper income earners and corporations. Nevertheless, with Congress set to pass a $550 billion infrastructure bill and a $3.5 trillion budget reconciliation bill, US fiscal policy will remain more stimulative over the next few years than it was in the pre-pandemic period. The same is likely to be true outside the US (Chart 8). Chart 8Fiscal Policy: Tighter But Not Tight Central Banks To The Rescue This brings us to monetary policy. In the post-GFC period, lower interest rates helped keep capital investment from falling more than it would have otherwise. In addition, lower rates discouraged savings, thus supporting consumption. And, with other central banks also cutting rates, the decision by the Fed to maintain low rates prevented the dollar from strengthening excessively. Beyond the direct benefits to the economy, lower rates increased the prices of long-duration assets such as equities and homes. This raised W in the equations above. The resulting “wealth effect” stoked consumer spending, while also encouraging new investment (particularly in real estate). Excess Savings Should Diminish Looking out, there are a few reasons to think that α and β will begin trending higher, leading to more spending and less need for ultra-accommodative monetary policies: Chart 9Wealth Accumulation Through The Ages Deleveraging pressures have abated. In the US, the ratio of household debt-to-disposable income has returned to pre-housing bubble levels. Debt-servicing costs are at a multi-decade low. Baby boomers are leaving the labor force. They hold over half of US household wealth, considerably more than younger generations (Chart 9). As baby boomers transition from being net savers to net dissavers, national savings will fall.   Chart 10A Tight Labor Market Eventually Bolsters Wages Governments are working to mitigate income inequality. Not only are redistributionist policies increasingly in vogue, but policymakers are trying to run economies hot. Historically, a tight labor market has curbed income inequality, while driving up workers’ share of overall income (Chart 10). Upside For Bond Yields, Both Near And Far Bond yields in the major economies likely hit a generational low last summer. Yields should rise over the coming years, first as slack diminishes, and later as structural forces reduce the amount of excess savings sloshing around the global economy. In the near term, a cresting of the Delta variant wave will prop up Treasury yields. While the number of new cases in the US continues to rise, the second derivative has turned for the better. A heat map shows that the weekly growth in new cases has slowed substantially in most US states (Chart 11). Chart 11The Delta Variant Wave Is Fading In The US Globally, the Delta variant wave is abating (Chart 12). The transmission rate has clearly peaked within the G7 (Chart 13). The number of cases has begun to fall in recent hot spots such as Indonesia and Thailand. And, after rising above 100, the 7-day average of new cases in China has fallen back to 30. Chart 12The Delta Wave Is Cresting Chart 13The Covid Transmission Rate Is Falling Again The tapering of bond purchases by the major central banks should also lift yields. Canada began tapering this past April. BCA’s fixed-income experts expect the Fed to start paring back purchases by the end of this year, with the ECB and BoE following suit in early 2022. We do not expect bond markets to become unhinged. Central banks would strongly push back against an excessive rise in yields. Nevertheless, a move in the US 10-year Treasury yield to 1.8% by early next year seems reasonable. Stocks Can Withstand Rising Bond Yields… For Now Chart 14Equity Valuations and Real Bond Yields Have Tended To Move In Tandem Equity valuations have broadly tracked real bond yields over the past few years (Chart 14). While higher yields will weigh on equity prices, there are a number of remaining tailwinds for stocks: Growth will remain above trend in the foreseeable future: Bloomberg consensus estimates foresee the global economy growing at an above-trend pace well into next year (Table 1). We agree with this assessment, and in fact, see upside risks to consensus growth forecasts. In particular, Chinese growth is likely to accelerate later this year as credit growth rebounds and fiscal spending increases. Local governments used less than 40% of their annual debt issuance quotas as of the end of July. Typically by that time of the year, they have used 70% of their quotas. Table 1Global Growth Will Remain Above Trend Well Into Next Year Forward earnings estimates will continue to drift higher: Analysts are usually too optimistic. As a result, they normally have to cut estimates over the course of the calendar year. This year has been different (Chart 15). In early July, analysts expected S&P 500 companies to generate about $45 in EPS in Q2. In the end, they generated about $53. Earnings are projected to decline in absolute terms in Q3 and remain below Q2 levels until the second quarter of next year, when they are anticipated to grow by a meagre 3.5% year-over-year (Table 2). As earnings estimates move up, stock prices will rise, even if P/E multiples move sideways. Chart 15Unusually, Analysts Have Been Revising Earnings Estimates Higher This Year Table 2US Earnings Estimates Have Upside Rising inflation expectations will lift nominal bond yields more than real yields: Investors expect inflation to come down rapidly over the coming months (Chart 16). The 5-year/5-year forward TIPS breakeven inflation rate is below the Fed’s comfort zone of 2.3%-to-2.5% (Chart 17).3 We think that US inflation will fall fast enough over the next few quarters to allow the Federal Reserve to maintain a fairly accommodative monetary stance, but not as fast as markets are discounting. Chart 16Investors Expect Inflation To Fall Rapidly From Current Levels The global equity risk premium remains elevated: We measure the equity risk premium (ERP) by subtracting the real 10-year bond yield from the forward earnings yield.4 Based on this measure, the global ERP stands at 634 bps (Chart 18). At the peak of the stock market boom in 2000, the global ERP was barely positive. Even in the US, where valuations are more stretched than abroad, the ERP stands at 574 bps. Remarkably, this is almost exactly where the ERP was in May 2008. An increase in the US 10-year Treasury yield to 1.8% by early next year – representing roughly a 50 basis-point increase from current levels in nominal terms and even less in real terms – would still leave US stocks attractively priced relative to bonds. Chart 17Below The Fed's Comfort Zone In summary, investors should remain overweight global equities on a 12-month horizon. A more cautious stance towards stocks will be appropriate in two years’ time once stagflationary forces begin to assert themselves. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 18The Global Equity Risk Premium Remains Elevated     Footnotes 1 Note that Gross Domestic Product should theoretically equal Gross Domestic Income. Thus, Y can denote either income or output. 2 For example, in a sample of five euro area economies, the European Central Bank found that the marginal propensity to consume out of wealth is higher for households at the lower end of the wealth distribution. 3 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 4 It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores