Industrials

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten Chart 2Natgas Storage Remains Tight Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Higher CO2 Emissions Follow Lower Renewables Output Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   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 crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 BRENT PRICES BEING VOLATILE BRENT PRICES BEING VOLATILE Chart 6 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Today we take a close look at the historical GICS1 level performance following the taper event in 2013.  Chart 1 provides an overview of a price action of the 10-year US Treasury yield, the US dollar, and gold to provide context, while Charts 2 - 4 summarize performance of the S&P sectors.   Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Chart 3 CHART 3 CHART 3 Chart 4 CHART 4 CHART 4 The Fed’s decision to modestly reduce the pace of its asset purchases in December of 2013 was a risk-off event which triggered a decline in Treasury yields and put upward pressure on the dollar. S&P 500 sectors followed the script from a risk-off “playbook” with Technology outperforming on the back of falling Treasury rates, while Financials underperformed.  A spike in USD also led to underperformance of the Energy sector. The Consumer Discretionary sector was a notable outlier underperforming the S&P 500 by 6%.  However, empirical analysis is hardly helpful in this case as in 2013 Amazon constituted 7.05% of the sector weight compared to 40% today. Finally, the performance of the defensive sectors was mixed as while tapering was perceived by the market as a clear risk-off event, it was also a sign that the economy is strong, and the Fed is comfortable with withdrawing the liquidity crutch. Bottom Line: Investors should not worry about the Fed and tapering as in the US its effect was short-lived and many more years of the bull market have ensued after it.    

Highlights We are reviewing our recommendations. We are also introducing recommendation tables to monitor these positions. Overall, our main recommendations have generated alpha and have a positive batting average. Feature The end of the month of August offers an opportunity to review the positions recommended in this publication. We introduce three tables corresponding to three investment horizons—tactical, cyclical, and structural—which summarize our main views. Each table is subdivided by asset class, namely equities, fixed income, and currencies. The tables can be found on page 12 and 13 and will be available at the end of future strategy reports. Tactical Recommendations Short Equity Leaders / Long Laggards This position is down 1.4% since inception. The idea behind this bet was that the easy money in the market had been made, and investors needed to become more discerning, although the big-picture economic backdrop continued to favor a pro-cyclical, pro-risk bias in a portfolio. To achieve this goal, we opted to buy cyclicals sectors that had lagged the broad market and to sell the ones that had already overtaken their pre-COVID highs, in the hope of creating a portfolio hedge. Practically, this meant buying sectors such as Industrials, Banks and Energy, while selling sectors such as Capital goods, Autos and Consumer services (Chart 1). This position has not worked out well as yields fell. Chart 1Leaders vs Laggards The Road So Far The Road So Far UK Mid-Cap And Small-Cap To Outperform This position is up 3.4% since inception. We initially favored the more domestically-oriented mid- and small-cap indices in the UK as a bet on the re-opening trade, following the lead taken by the UK in the global vaccination campaign. A faster re-opening would not only boost the ability of smaller domestic firms to generate cash flows, it would also elevate the pound, which would hurt the profit translation of the multinational dominating the UK large-cap indices. By mid-May, we opted to move small cap back to neutral, as the positive story was well discounted and we expected the GBP to correct, which would help large-cap stocks. Favor European Banks Relative To US Ones This position is up 4.1% since inception. It is mainly a value trade. The European economy has lagged behind that of the US, and European yields remain well below US ones. As a result, European financials have greatly underperformed their US counterparts. However, this performance differential has left European banks trading at an enormous discount relative to their US peers. Hence, as continental European economies were catching up to the US on the vaccination front, we expected European banks to regain some ground. This trade has further to go, as valuation differentials remain excessive, especially since European banks are not as risky as they once were. Underweight / Short Norway As Hedge To Swedish Stocks This position is down 1% since inception. We have a cyclical overweight on the Swedish equity market (see page 9), which is extremely sensitive to the global industrial cycle. Thus, we were concerned by the potential near-term impact of the Chinese credit slowdown on this position. Selling Norway remains an appropriate hedge, because this market massively overweight materials stocks, which are even more exposed to the Chinese credit cycle than industrials are. Positive European Small-Cap Stocks This position is up 0.2% since inception. This was a bet on the economic re-opening taking place in the wake of the accelerating pace of vaccination in Europe. However, the weakness in the Euro since May has caused the large-cap European stocks to perform almost as well as their more-domestically focused counterparts. Neutral Stance On Cyclicals Relative To Defensives Chart 2The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance This trade is up 2.3% since inception. While we like cyclical plays on an eighteen to twenty-four months basis, we became concerned this spring about a tactical pullback. Globally, cyclical stocks had become extremely expensive and overbought relative to defensive sectors (Chart 2). Moreover, the rapid deceleration of the Chinese credit impulse pointed toward a period of negative economic surprises and was historically consistent with a period of underperformance of cyclical names. Now that China is stepping off the brake pedal, this trade is becoming long in the tooth. Neutral Stance On Europe Relative To The Rest of The World This trade is down 0.3% since its inception. This position is a corollary to the neutral view on cyclicals, as European equities possess a high beta. This bet did not pan out; European equities did underperform US stocks, but weaknesses in China and EM undid this benefit. Favoring Industrials Over Materials This trade is up 0.6% since inception. Industrial equities are less exposed to the Chinese credit slowdown than materials, but are more direct beneficiaries of the large infrastructure spending packages being rolled out across advanced economies. Industrials are also a direct bet on a capex recovery, which we expect to intensify over the next two years as companies address supply side issues. The tactical element of this trade may soon dissipate as China’s policy tightening ends, which would warrant booking profits. However, the industrials versus materials theme remains attractive as a cyclical bets on capex. Financials Over Other Cyclicals This trade is down 1.6% since inception. This was another trade aiming to keep some cyclical exposure on the book (long financials), while diminishing the exposure to the Chinese credit slowdown. The fall in yields and the weakness in the euro prevented this trade from working out. We now close this position. Long / Short Basket Based On Combined Mechanical Valuation Indicator This trade is flat since inception. This market-neutral trade uses the methodology developed in our May 31st Special Report in which we introduced our Combined Mechanical Valuation Indicator (CMVI). We bought the most undervalued sectors and sold the most overvalued. We will look to rebalance this portfolio in the coming months. Short Euro Area Energy Stocks / Long UK Energy Stocks Chart 3UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain This trade is up 7.5% since inception. This market neutral trade was fully based on the results from our CMVI (Chart 3). We are taking profits today. Short Consumer Discretionary / Long Telecommunication In Europe This trade is up 10.6% since inception. It is our favored way to express our tactical worries toward cyclical equities and the resulting preference for defensive stocks. Moreover, this trade is attractive from a valuation perspective, as the CMVI gap between discretionary and telecommunication equities is at a record high despite the higher RoE offered by telecom equities (Chart 4). Short Tech / Long Healthcare In Europe This trade is up 9.3% since inception. It is a low-octane version of the short discretionary / long telecommunications position. While it is a short cyclicals / long defensive trade, it does not have the long value / short growth overlay as its higher-octane cousin. However, it is also supported by attractive valuation differentials (Chart 5). Chart 4An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... Chart 5...and A Lower Octane Expression ...and A Lower Octane Expression ...and A Lower Octane Expression Favor Spain Over France This trade is down 2% since inception. Based on sectoral composition, the Spanish market is more defensive than that of France, which was an appealing characteristic considering our tactical worries for cyclical bets. Moreover, Spanish equities were more attractively priced. However, the Spanish economy has proven less resilient to the Delta variant than that of France. As a result, Spanish financials, which represent a large share of the national benchmark, have suffered. Underweight French Consumer Discretionary Equities Relative To Global Peers This trade is up 0.6% since inception. French discretionary stocks, led by beauty and luxury names, remain attractive structural plays. However, they have become expensive and risk temporarily underperforming their foreign competitors. Buy Swiss Equities / Sell Eurozone Defensive This trade is up 0.5% since inception. Due to their sectoral bias toward consumer staples and healthcare, Swiss equities are extremely defensive. However, they often outperform their Euro Area counterparts when Swiss yields rise relative to those of Germany. We do expect such widening to take place over the coming months. The ECB will continue to expand its balance sheet, which will force the SNB to become increasingly active about putting a floor under EUR/CHF. Historically, these processes boost Swiss stocks relative to Eurozone defensives. Buy European Momentum Stocks / Sell European Growth Stocks Chart 6The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further This trade is up 1.7% since inception. In Europe, momentum stocks are exceptionally oversold relative to growth stocks (Chart 6). As yields stabilize, momentum stocks are well placed to outperform growth equities. Moreover, this trade is a careful attempt to begin to move away from our defensive tactical stance as China backs away from policy tightening. More Value Left In European IG This trade is up 0.9% so far. European IG bonds have low spreads, but their breakeven spreads may narrow further as policy remains extremely accommodative and European growth continues to recover, even in the face of the Delta variant. In this context, we see the modest yield pick-up offered by these products as attractive, especially compared to the meagre yields generated by European safe-haven securities. Despite the modest success of the overall recommendation, the country implication did not work out as well. Overweight Italian And Spanish Bonds In Balance Portfolios This trade is up 0.2% since inception. Italian and Spanish government bonds are expensive in absolute terms, but compare well relative to French, Dutch, or German bonds. In a backdrop in which the ECB continues to purchase these instruments, where the NGEU funds create an embryo of fiscal risk-sharing within the EU and where growth is recovering, risk premia in the European periphery have room to decline further. Buy European Steepeners And US Flatteners As A Box Trade Chart 7Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners This trade is up 63 bps since inception. The ECB will lag behind the Fed, but market pricing already reflects this future. Meanwhile, the terminal policy rate proxy embedded in the EONIA and US OIS curves overstates how high the neutral rate is in the US compared to that of Europe (Chart 7). Thus, as the Fed begins to remove accommodation in the US, the US yield curve should flatten compared to that of Europe. Favor The GBP Over The EUR This trade is up 0.6% since inception. The pound is cheaper than the euro, and the domestic UK economy is well supported by the more advanced re-opening process. This combination will continue to hurt EUR/GBP. Sell EUR/NOK This trade is down 2.6% since inception. The NOK is cheaper than the EUR, and the Norges Bank will lead DM central banks in raising interest rates. Moreover, higher oil prices create a positive term of trade shock in favor of Norway. However, this trade has not worked out so far. Among G-10 currencies, the NOK (along with the SEK) is the most sensitive to the USD’s fluctuations. The rebound in the Greenback since March has therefore hurt this position significantly. Cyclical Recommendations Overweight Stocks Vs Bonds This position is up 7% since inception. European equities follow the global business cycle; while we warned a slowdown would take shape, growth is slated to remain above trend for the foreseeable future. Consequently, while we may adjust tactical positioning to take advantage of these gyrations in growth relative to expectations, our core cyclical view remains to overweight stocks within European balanced portfolios. Overweight Bank Equities Chart 8Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore This position is up 2.4% since inception. We have espoused the near-term decline in yields, but our big picture cyclical view remains that yields have more upside globally. An environment in which yields increase is one in which bank profit margins expand, which will in turn boost the relative return of cheap financial equities. Even though the long-term growth rate of bank cash flows warrants a discount, these firms’ valuations also reflect the perception that they carry elevated risks. However, if European NPLs have greatly improved, capital buffers have expanded significantly (Chart 8), and the ECB is unwilling to precipitate a crisis as it did ten years ago. In this context, the risk premia embedded in European bank valuations have room to decrease, which will boost the relative performance of these equities. Bullish German Equities (Absolute) This position is up 3.9% since inception. German stocks are a direct bet on the global economy, as a result of their heavy weighting in industrials and consumer discretionary stocks. Moreover, the German economy continues to fare well, boosted by a cheap euro and a low policy rate. Finally, we expect German fiscal policy to remain accommodative after the upcoming federal election weakens the power of the CDU. This combination will allow German stocks to generate further upside over the coming years. Favor Swedish Equites Over Eurozone And US Benchmarks Since inception, this position is up 0.9% on its European leg and is up 0.3% on its US leg. Sweden is a particularly appealing market despite its demanding valuations. The Swedish benchmark overweighs industrials and financials, two of our favorite sectors for the coming eighteen months. Moreover, the Swedish corporate sector’s operating metrics are robust, with wide profit margins, elevated RoEs, and comparatively healthy levels of leverage. Finally, the SEK is one of our favored currencies on a twenty-four-month basis, because it has a strong beta to the USD, which BCA expects to depreciate on a cyclical time frame. Buying Sweden versus the Eurozone has worked out, but selling the US market has not, because yields experienced a countertrend decline. Once global yields begin to rise anew and Chinese credit growth begins to recover, Swedish equities should also beat their US peers. Long Swedish Industrials / Short Eurozone And US Industrials Chart 9Favor Swedish Industrials Favor Swedish Industrials Favor Swedish Industrials This position is up 3% on its European leg and 8.5% on its US one. This market neutral position narrows in on the very reason to favor Swedish equities: industrials. As is the case for the overall market, Swedish industrials offer stronger operating metrics than their counterparts in both the Eurozone and the US (Chart 9). Additionally, the early positioning of Sweden in global supply chains adds some operating leverage to these firms, which gives them an advantage in an environment of continued inventory rebuilding, infrastructure spending, and capex plans around the world. Underweight German Bunds Within European Fixed-Income Portfolios German bund yields have declined 15bps since inception. German Bunds suffer from their extremely demanding valuations versus other European fixed-income securities. As long as global and European growth remains above trend, German yields should underperform other European fixed-income assets, even if the ECB stands pat for the foreseeable future (which would force greater spread compression across European markets). Weakness In EUR/USD Creates Long-Term Buying Opportunities Earlier this spring, we expected the dollar to experience a counter-trend bounce as a result of skewed positioning and the potential for a decline in global growth surprises. However, BCA’s cyclical view calls for a weaker USD because of the US balance of payments deficit, the greater tolerance of the Fed for higher inflation, and the overvaluation of the Greenback. Based on these diverging forces, we continue to recommend investors use the current episode of weakness in EUR/USD as an opportunity to garner more exposure to the euro. Short EUR/SEK This position is down 0.6% since inception. The SEK is even more sensitive to the dollar’s gyration than the euro. Moreover, beyond some near-term disappointment in global economic activity, we expect global growth to remain generally robust over the coming eighteen months. This combination will allow the SEK to appreciate versus the EUR, especially when Sweden’s domestic economic activity and asset markets are stronger than that of the Eurozone. Structural Recommendations A Structural Underweight On European Financial Chart 10Too Much Capital Too Much Capital Too Much Capital This long-term position is at odds with our near-term optimism about the sector. However, Europe has an excessively large capital stock, which, relative to GDP, dwarves that of the US or China (Chart 10). This phenomenon hurts rate of returns across the region and will remain a long-term structural handicap for the financial industry. Hence, investors with long investment horizons should use the expected rebound in European financials over the next year or two to diminish further their exposure to that sector. Norwegian Equities Remain Challenged As Long-Term Holdings Norwegian stocks overweight the financials, materials, and energy sectors. While materials face a bright future as electricity becomes an even more important component of the global energy mix, financials and energy face deep structural headwinds. Moreover, the krone faces its own structural challenges (see below). This combination augurs poorly for the long-term rates of return of Norwegian stocks. Overweight French Industrials Relative To German Ones This position is a bet on the continuation of the reform efforts of the French economy. BCA expects Emmanuel Macron to win a second mandate next year, which should result in additional reforms to the French economy. As a result, the French unit labor costs should remain contained relative to those of Germany. This process will help the profit margins of French industrial firms relative to that of their competitors across the Rhine. Overweight French Tech Equities Relative To European Ones French tech stocks will benefit from the greater R&D subsidies and budgets promoted by the French government. The Euro Will Underperform Pro-Cyclical European Currencies The Swedish krona and the British pound are particularly attractive versus the euro on a long-term basis. They benefit not only from their cheaper valuations, but also from the fact that the Riksbank and the Bank of England will tighten policy considerably ahead of the ECB. Additionally, the SEK and the GBP are now both more pro-cyclical than the euro. The Norwegian Krone Faces Structural Challenges The NOK is cheap and may even benefit in the coming month from its historical pro-cyclicality. However, Norway suffers from declining productivity relative to that of its trading partners, which creates a strong long-term handicap for its currency. As a result, long-term investors should withdraw from the NOK.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations The Road So Far The Road So Far Cyclical Recommendations The Road So Far The Road So Far Structural Recommendations The Road So Far The Road So Far ​​​​​​​ Currency Performance Fixed Income Performance Equity Performance  

Highlights Earnings season was impressive, with 87% of companies beating analyst earnings expectations. Analysts’ targets were too low because a whopping 38% of companies provided negative forward guidance for the Q2-2021 results. The markets expect 12-17% earnings growth over the next 12 months. Growth is past its peak and is returning to trend. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet, returns will be lower than in the past due to high valuation “speed limit.” US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent up demand for elective procedures will propel earnings growth higher. Overweight Industrials to benefit from the US manufacturing Renaissance long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Feature The Q2-2021 earnings season is coming to an end, and it is time to take stock of the companies’ results and validate our equity views on styles, sectors, and investment themes into the balance of the year. Review Of The Q2-2021 Earnings Season The S&P 500 Key Earnings Results Stats S&P 500 quarterly earnings grew 93% YoY, and sales increased by 23.5% YoY compared to the same quarter a year ago (Table 1). Q2-2021 earnings stand 29% above the Q2-2019 level, which translates into 14% annualized growth. CAGR for sales for the same period is 4.6%. 87% of the companies have beaten both sales and earnings expectations. Earnings surprise is 16%, while sales surprise is 4.6%. As our colleagues from US Investment Strategy (USIS) have observed, beats are unprecedented: Their magnitude is more than two standard deviations above the historical average (Chart 1). Table 1S&P 500 Q2-2021 Earnings And Sales Results Decoding Earnings Decoding Earnings Chart 1Earnings Surprises Are Unprecedented Decoding Earnings Decoding Earnings Decoding The S&P 500 Earnings Season Results While we are impressed with the earnings results delivered by the US companies, our reaction to these superb growth numbers and beats is tepid, like the market’s reaction. The average reaction to an EPS beat this earnings season was about 0.9%. Misses were penalized harshly with stocks falling 1.1%. S&P 500 is up only 2% since the beginning of the reporting season. There are a few reasons for this lukewarm reception: Analyst targets were too low: Ubiquitous beats of earnings and sales expectations indicate that the analyst targets were too low despite upgrades throughout the earnings season (downgrades are more typical). The bar was set too low because a whopping 38% of the companies provided negative forward guidance for the Q2-2021 results. Growth was lumpy: Much of the robust growth can be explained by what we can call two sides of the same coin, one being a low base for the comparisons – after all, in the summer of 2020, the economy was close to a standstill – and the other is a pent-up demand for goods and services. In other words, all the growth postponed in 2020 was delivered at once over this past couple of quarters. With that, a 14% annualized growth rate for the S&P 500 earnings since 2019, which smooths results over time, is strong but not exceptional. Corporate guidance was cautious: Many companies have warned investors that their high growth rates are unsustainable (31% of companies guided lower for Q3-2021). Since the markets are forward-looking, reported earnings growth is seen in the rearview mirror and is priced in, and it is future growth that matters. Earnings growth has returned to trend: Earnings have fully recovered from the pandemic dip. The street bottom-up EPS growth projections (according to Refinitiv) for the rest of 2021, 2022, and 2023 are based on that assumption (Chart 2). The corollary to the point above is that earnings growth has peaked (Chart 3, RHS): Earnings will grow forward along the trend line at about 6-8% annually, which is the historical average. Chart 2Earnings Growth Is Returning To Trend Decoding Earnings Decoding Earnings What To Expect Over The Next Four Quarters? According to the data compiled by Refinitiv, analysts expect Q3-2021 earnings to be 5% (QoQ) below their Q2-2021 level, staying flat for the next couple of quarters and exceeding the current level only in Q2-2022 (Chart 3, LHS). Aggregating quarterly growth rates into next 12 months growth rate, analysts expect 12.6% YoY growth over the next 12 months. Chart 3Growth Has Peaked And Quarterly Earnings Are Expected To Be Almost Flat Decoding Earnings Decoding Earnings We believe that these growth expectations are too low, as they are based on the expectation that over the next four quarters EPS will stay practically flat. Therefore, most of the 12.6% YoY growth can be attributed to a base effect. It is likely that YoY growth will be higher: Some sector earnings are still at a pre-pandemic level, while others should grow simply because the economy is expanding. IBES expects EPS NTM to grow at 17% over the next 12 months, which is slightly more realistic in our opinion (Chart 4). The difference with Refinitiv is in the calculation methodology. Our working assumption is that next year’s growth will be within the 12-17% YoY range. From Multiple Expansion To Earnings Growth! Return decomposition demonstrates that in 2020, the S&P 500 return was 26%, with 43% contributed by the multiple expansion, and 19% detracted by the earnings contraction: Over the past year, returns have been borrowed from the future, but this year is payback time. The source of the equity returns is shifting from multiple expansion to earnings growth. This means that 12%-17% expected EPS growth (and possibly more if we get a positive earnings surprise) in the upcoming four quarters will propel the markets higher (Chart 5). Chart 4IBES Expect Next 12 Months Growth To Be 17% IBES Expect Next 12 Months Growth To Be 17% IBES Expect Next 12 Months Growth To Be 17% Chart 5Earnings Growth Replaces Multiple Expansion As A Driver Of Returns Decoding Earnings Decoding Earnings Will the S&P 500 Grow Into Its Big Valuations Shoes? Not So Fast At present, the S&P 500 is trading at 21.3x forward earnings (PE NTM), which is steep compared to a historical average of 18x. PE NTM multiples will compress if earnings growth exceeds index price appreciation. While we do expect multiple expansion to pass the baton to earnings growth over the next 12 months, we are curious to know by how much earnings would have to grow for PE to come down to 18x. To get an answer, we created a scenario analysis matrix, varying price and earnings growth simultaneously. The most likely scenario is for the earnings to grow at 3-5% each quarter over the next 12 months (13-16% annualized) and, assuming that the S&P 500 price does not move, it will trade at 20.5-21x forward earnings multiples. For PE to come down to 18x, earnings would have to grow by more than 10% every quarter, or 30% over the next 12 months, which is way above the growth rates expected by the market. Therefore, we are unlikely to see significant multiple compression without a market correction (Table 2). US equities are expensive, no excuses. Table 2Earnings Have To Grow in Double-Digits For PE NTM To Come Down To 18x Decoding Earnings Decoding Earnings Zooming In On The US Equity Market Segments Table 3Style Indices Q2-21 Sales And Earnings Growth Decoding Earnings Decoding Earnings Value Outgrew Growth: Earnings of Value grew 31% faster than earnings of Growth (Table 3). However, looking under the hood, annualized EPS growth of Growth was 16% p.a. since 2019, while EPS of Value contracted by 2% p.a. This means that for many Value companies, the earnings surge is a function of the base effect; earnings have not yet reached their pre-pandemic levels (Chart 6) and have room to run further. Chart 6Small Delivered Spectacular 2019-2021 Growth Decoding Earnings Decoding Earnings Small Crushes Earnings: Small Caps' quarterly results have been nothing short of astonishing: EPS in Q2-21 is 10 times higher than during the same quarter a year ago. This growth surge can’t be attributed just to the base effect, as earnings are double what they were two years ago. The S&P 600 has an annualized earnings growth rate over the past two years of 42%, and sales growth of 6.2%. Sectors Sector results are characterized by a powerful rebound of the cyclical sectors: Industrials, Consumer Discretionary, Energy, Materials, and Financials have delivered triple-digit earnings growth, and double-digit sales growth (Table 4). Table 4S&P 500 Sectors' Q2-21 Sales And Earnings Growth Decoding Earnings Decoding Earnings However, looking at 2019-2021 CAGR, we observe that the Industrials sector earnings are still 10% below the 2019 level, and the Consumer Discretionary sector has only grown 2% annualized, much slower than the market. The case is the same for Energy. Financials and Materials growth was very strong: The former benefited from the M&A and IPO boom, while the latter has grown thanks to stimulative Chinese policy, which has been tightened lately (Chart 7). Chart 7Cyclical Sectors Did Not Grow Much Since 2019 Despite Recent Profit Rebound Decoding Earnings Decoding Earnings Profitability Is Unlikely to Return To A Previous Peak Many companies have tightened their belts during the pandemic to preserve capital in the face of uncertainty. Margins have compressed, but less than expected in such a dire situation. Currently, the majority of sectors has margins close to their historical averages (Chart 8). While most sectors, with exception of Financials and Technology, are below peak margins, it is unlikely that they will be able to return to their former highs. Sales will soar thanks to stimulative fiscal and monetary policies, strong demand by consumers, and inflation. Yet the bottom line may be impeded by the increases in labor and input costs and tighter fiscal policy, which have not yet been priced in by the market. Market Expectations For The Next 12 Months According to IBES, earnings growth will be propelled by the cyclicals, such as Industrials, Consumer Discretionary and Energy (though less so as it is a small sector). These expectations are well aligned with our investment thesis (Chart 9). Chart 8Most Sectors' Margins Are Back To Normal, But Peak Margins Are Elusive Decoding Earnings Decoding Earnings Chart 9Cyclical Sectors Are Expected To Grow The Most Over The Next 12 Months Decoding Earnings Decoding Earnings Investment Themes Consumers Are Flush With Cash One of our key investment themes is that the US consumer still has plenty of money to spend: Excess savings in the US currently stand at $2.5 trillion, and disposable incomes have been padded by the pandemic helicopter cash drops. While spending on goods had exceeded its historical trend and has recently turned, spending on services is still below pre-pandemic levels (Chart 10). During Q2-2021, Consumer Services earnings grew by 154%, exceeding analyst targets by 27%, though the level of earnings is only 5% above the Q2-2019 level (Chart 11). This suggests that the theme has worked, but also that it has the potential to run further only if not derailed by the fear of COVID-19 variants. However, the approach to investing in this sector needs to be granular, with overweights allocated to service industries such as hotels, restaurants, and leisure (S&P leisure products, S&P hotels, S&P restaurants). Chart 10Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Chart 11The Consumer Discretionary Sector Growth Will Stay Robust The Consumer Discretionary Sector Growth Will Stay Robust The Consumer Discretionary Sector Growth Will Stay Robust We recommend staying away from Internet Retail (downgrade is pending) and the other sectors that have outsized exposure to consumer goods. Amazon earnings were a case in point: The company disappointed analysts with weaker revenue growth as well as provided a more cautious outlook as it finds it difficult to surpass its stellar pandemic numbers. Brick and mortar retail is likely to fare better, as going out to shop now falls into the “experiences” basket. China Slowdown: Underweight The Materials Sector Chinese growth is slowing, which has an adverse effect on demand for industrial metals (Chart 12). As a result, we have underweighted the Materials sector, along with the Metals and Mining industry. This call was on the money: While Materials more than doubled earnings over the past year, its earnings surprise at 6.40% is the smallest of all the sectors. The Materials sector has underperformed S&P 500 by 8% since the beginning of June. Chart 12Materials Sector Earnings Growth Is Slowing Materials Sector Earnings Growth Is Slowing Materials Sector Earnings Growth Is Slowing Post-COVID-19 Normalization: Overweight The Health Care Sector We upgraded this sector to an overweight three weeks ago. We intended to add a defensive sector in our portfolio to make it more robust in the face of an imminent market pullback, likely volatility on the back of elevated valuations and the upcoming debt ceiling kerfuffle. This quarter, Health Care posted mixed results despite being among the key beneficiaries of the pandemic. There are several factors at play. One is that some US vaccine manufacturers pledged to produce vaccines at no profit (J&J). Another reason is that the pandemic forced hospitals to halt their non-emergency operations that serve as an important end-demand market for the S&P Health Care sector. Weak Q2-2021 earnings suggest untapped demand for medical services and elective procedures. Just now, hospitals started reopening, and we expect a spike in the number of hospital visits, with positive spillover effects for medical equipment manufacturers and pharmaceutical companies. We are sticking to our overweight unless Delta and Lambda take over the hospital beds. US Manufacturing Renaissance The Industrials delivered triple-digit growth, but the sector’s earnings are still below pre-pandemic levels. There was an earnings growth dichotomy at play. Manufacturing companies that derive a high percentage of earnings from abroad have been affected by a slowdown of Chinese demand and by inflationary pressures. CAT’s recent 20% drawdown in relative terms encapsulates these headwinds. Domestic and services-oriented stocks like railroads reported exceptionally strong demand. Looking ahead, we are constructive on the sector. There is still significant pent-up demand for industrial goods and services, inventories are historically low (Chart 13) and need to be replenished, Federal infrastructure spending is a near certainty, and onshoring of US manufacturing is a new structural theme. Analysts concur: Expected EPS growth for the sector over the next 12 months is 46%. Chart 13Inventories Are At All Time Low Inventories Are At All Time Low Inventories Are At All Time Low Chart 14Value-Growth Earnings Growth Differential Is Closing Value-Growth Earnings Growth Differential Is Closing Value-Growth Earnings Growth Differential Is Closing Rate Stabilization: Overweight Technology and Growth vs Value Technology is one of our core overweights in the portfolio and the sector fared well last quarter. One of the drivers behind the strong quarter is an accelerating shift to remote work as companies re-evaluate the need for offices, especially given the possibility of new virus variants. A similar upbeat message came from the semiconductor industry: A shortage of chips that touches all corners of manufacturing from cars to computers, translates into strong earnings growth, which is likely to continue far into the future. As our BCA colleague, Arthur Budaghyan observed, semiconductor chip manufacturing is becoming a strategic asset, especially in a standoff between China and the US, and the country that controls the production of semis controls the production of most tech goods. We have been overweight Growth vs Value in our portfolios since the beginning of June. Since then, Growth has outperformed Value by about 6%. While Value was growing faster than Growth in Q2-21, the earnings growth expectation between Growth and Value is closing. After a strong run, Growth is expensive again, trading at 28x forward earnings compared to 16x for Value. We expect the yield curve to steepen and yields to rise this fall once workers return to work and the unemployment rate falls further. In other words, we are edging closer to downgrading Growth to neutral; we are just waiting to get more visibility on the Delta variant scare. Upgrade Small vs Large When Rates Rise Again Back in June, we wrote a deep-dive report on Small / Large cap allocation and concluded that an equal-weighted allocation was warranted. This call has not worked so far as Small has underperformed Large by about 5%. Our reasons for not overweighting Small vs Large were manifold: Slowing growth, flattening yield curve, mean reversion of high-yield spreads and, most importantly, a significant downgrade of earnings expectations (Chart 15). Chart 15Small Cap Downgrades Likely Ran Their Course Small Cap Downgrades Likely Ran Their Course Small Cap Downgrades Likely Ran Their Course However, we are warming up to Small: Reported earnings and sales growth was impressive. Furthermore, we expect the yield curve to steepen (helping banks in the S&P 600) as people go back to work in September, and rates to go up to as high as 1.8% by the end of the year. When the timing is right, we will swap overweight in the Growth stocks to an overweight in Small. Investment Implications The earnings season was impressive, but growth is returning to trend and is past its peak. The markets expect 12-17% earnings growth over the next 12 months. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet returns will be lower than in the past due to a high valuation “speed limit.” The US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent-up demand for elective procedures will propel earnings growth higher. Overweight Industrials which will benefit from the US manufacturing Renaissance over the long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending over the short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Bottom Line The earnings season produced peak growth, and the next phase of the cycle is earnings growth returning to trend. This normalization will be a tailwind for the equity markets and will replace multiple expansion as a driver of equity returns. We are sticking to our overweights in Industrials, Health Care and Consumer Discretionary, and our underweight in Materials. We are reconsidering our overweight in Growth and neutral positioning in Small Caps. Once rates turn up decisively, a rotation into Small and Value is warranted.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Foreword Today we are publishing a charts-only report focused on the S&P 500 and its sectors. Many of the charts are self-explanatory; to some we have added a short commentary.  As with the styles Chart Pack, published a month ago, the sector charts cover macro, valuations, fundamentals, technicals, and the uses of cash.  Our goal is to equip you with all the data you need to underpin sector allocation decisions.  We also include performance, valuations, and earnings growth expectations tables for all the styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We plan to update it monthly, alternating sector and style coverage. Overarching Investment Themes Macro Economic surprise index is flagging while Q2-21 earnings surprises are unprecedented.  Much of the good economic news has been priced in and the Citigroup Economic Surprise Index is hovering around zero (Chart 1A).  Most of the economic indicators have turned, confirming that the surge in growth has run its course and the macroeconomic environment is normalizing. Covid-19 fears are resurfacing:  The spread of the Delta variant is unlikely to trigger another lockdown, but consumers may curtail their activities out of fear of infection, adversely affecting demand for goods and services.  However, for now, we are sanguine about this risk. Investors expect inflation to roll over: Investors’ inflation fears are dissipating, attested by the falling 5Y/5Y inflation breakevens (Chart 1B).  Indeed, it appears that the debate on the persistence of inflation has been won by the “inflation is transitory” camp.  Yet, we won’t be surprised if inflation surprises on the upside (no pun intended).  Chart 1AGood Economic News Has Been Priced In Good Economic News Has Been Priced In Good Economic News Has Been Priced In Chart 1BMost Investors Are Now Convinced That Inflation Will Be Transitory Most Investors Are Now Convinced That Inflation Will Be Transitory Most Investors Are Now Convinced That Inflation Will Be Transitory Labor shortages are starting to dissipate: On the labor front, companies are still struggling to fill job openings.  However, there are signs that the labor market is healing, with more and more workers interested in returning to the labor force  (Chart 2). Inventories will be replenished, spurring investment: Post-pandemic economic recovery is still plagued by the mismatch between supply and demand. Supply-chain disruptions and shortages fail to meet pent-up demand of consumers eager to spend “helicopter drop cash” and accumulated savings.  As a result, inventories have been drawn down, chipping away 1.1% from GDP growth. In fact, they are at all-time lows: Non-farm inventories to final sales have dropped lower than they were during the GFC (Chart 3).  Low inventories will have to be replenished, resulting in further gains in investment and providing a boost to industrial activity going forward. Chart 2More Workers Are Interested In Returning To The Labor Force US Equity Chart Pack US Equity Chart Pack Demand for services will continue to exceed demand for goods: Last, but not least, consumers have money to spend but are shifting away from goods and toward services and experiences.  Consumer expenditure on goods is above trend and has recently turned down, while spending on services is still below pre-pandemic levels, and rebound is still running its course (Chart 4). Chart 3Inventories Are At All Time Low Inventories Are At All Time Low Inventories Are At All Time Low Chart 4Real Spending On Services Is At PrePandemic Levels: Room For Further Rebound Real Spending On Services Is At PrePandemic Levels: Room For Further Rebound Real Spending On Services Is At PrePandemic Levels: Room For Further Rebound Valuations And Profitability The US stock market remains expensive: The S&P 500 is trading more than two standard deviations above the long-term average.  However, there are pockets of reasonably priced, albeit unloved, stocks within the S&P 500: Telecom (11x forward earnings), Health Care (17x), Energy (14x), and Financials (14x).  Earnings continue to crush expectations: While equities are expensive, they are redeemed by the strong showing of earnings and sales growth reported for Q2-2021.  The scale of earnings beats relative to analyst expectations is spectacular: Running at nearly 20%, or more than two standard deviations above the historical average (Chart 5). Chart 5Earnings Surprises Are Unprecedented US Equity Chart Pack US Equity Chart Pack Earnings growth is normalizing: Earnings have increased 90% over the lackluster Q2, 2020.  Compared to Q2-2019 as a baseline quarter, earnings are up 22%, pointing to normalization going forward.  Earnings growth will become a tailwind for the outperformance of equities into the balance of the year and will help the S&P 500 to grow into its big valuation “shoes”. Margins are expanding despite inflation:  Many sectors are able to grow earnings and recover margins despite increases in costs of raw materials and labor, thanks to their strong pricing power, i.e., ability to pass on higher input costs to their customers (Chart 6A).  Sectors with the highest pricing power are: Communications Services, Consumer Discretionary, Industrials, Energy and Materials.  They are the best inflation hedges. Chart 6ACompanies' Profitability Is Improving To Pre-Pandemic Levels Companies' Profitability Is Improving To Pre-Pandemic Levels Companies' Profitability Is Improving To Pre-Pandemic Levels Uses Of Cash Cash to be disbursed to shareholders: Share buybacks and other shareholder-friendly activities are on the rise again and are expected to gain steam this year and next.  This is supported both by strong earnings growth, healthy balance sheets, and regulatory headwinds to any potential M&A activity due to the anti-trust stance of the current administration Capex is about to make a comeback: Capex is still lagging across most sectors.  A pickup in capex will signal that the post-pandemic recovery is firmly on track, and companies are comfortable investing in future growth.  However, there are early signs that that is about to change.  Philly Fed survey shows that over 40% of respondents are planning to increase their capex expenditure  (Chart 6B). Chart 6BCapex Increases Are On The Way Capex Increases Are On The Way Capex Increases Are On The Way Investment Implications Overweight sectors and industry groups exposed to consumer services spending (airlines, hotels, leisure) and be selective about consumer goods and retailing industry groups: Real PCE for goods has turned down toward the trend line.  Exceptions are areas of the market with well-publicized shortages such as Autos and Parts. Overweight Industrials – US manufacturing has limited capacity, onshoring is a new trend, inventories need to be replenished, and capex intentions are on the rise. Overweight Health Care – growth slowdown favors this defensive sector, which also benefits from a backlog of demand for medical procedures and services. Reflation trade is out of the picture, now that inflation fears have abated and the Delta variant preoccupies investors.  For that, we still favor Growth over Value.  Yet, we watch this allocation closely, to time rotation once Covid-19 fears dissipate, rates pick up and inflation surprises on the upside. With valuations high, and forward returns expectations lackluster, we favor sectors likely to delivery healthy cash yield: Financials, Health Care, Energy, and Technology.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 7Macroeconomic Backdrop And Earnings Surprise Macroeconomic Backdrop And Earnings Surprise Macroeconomic Backdrop And Earnings Surprise Chart 8Profitability Profitability Profitability Chart 9Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 10Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 11Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 12Profitability Profitability Profitability Chart 13Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 14Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 15Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 16Profitability Profitability Profitability Chart 17Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 18Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 19Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 20Profitability Profitability Profitability Chart 21Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 22Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 23Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 24Profitability Profitability Profitability Chart 25Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 26Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 27Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 28Profitability Profitability Profitability Chart 29Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 30Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 31Health Care: Sector vs Industry Groups Health Care: Sector vs Industry Groups Health Care: Sector vs Industry Groups Chart 32Profitability Profitability Profitability Chart 33Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 34Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 35Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 36Profitability Profitability Profitability Chart 37Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 38Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 39Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 40Profitability Profitability Profitability Chart 41Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 42Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 43Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 44Profitability Profitability Profitability Chart 45Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 46Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 47Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 48Profitability Profitability Profitability Chart 49Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 50Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 51Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 52Profitability Profitability Profitability Chart 53Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 54Uses Of Cash Uses Of Cash Uses Of Cash  Table 1Performance US Equity Chart Pack US Equity Chart Pack Table 2Valuations And Forward Earnings Growth US Equity Chart Pack US Equity Chart Pack Recommended Allocation   Footnotes  

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Global Policy Uncertainty Revives Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 10US Ends Trade War With Europe? Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk Russia's Domestic Political Risk Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Cyber Security Stocks Recover Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Long UK Versus Eastern Europe Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Long GBP Versus CZK Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 20Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 21BGerman Greens Still Underrated Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 23Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Mexico To Outperform Latin America Mexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America China's Slowdown Will Hit South America China's Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Chart 2Global Manufacturers' Prices Moving Higher Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations Commodity Price Increases Reflected in CPI Inflation Expectations Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Oil Prices Are Key To 5Y5Y CPI Swap Rates Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold Weaker USD Supports Gold Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View BCAs Gold Fair-Value Model Supports $2000/oz View BCAs Gold Fair-Value Model Supports $2000/oz View Chart 8Sentiment Supports Oil Prices Sentiment Supports Oil Prices Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Chart 10Wider Vaccine Distribution Will Support Gold Demand Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       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 The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices Chart 12 Platinum Prices Going Up Platinum Prices Going Up Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

In the previous Tinkering With Inflation Special Report, we outlined our structural view for US inflation, namely that over the next 10 years inflation will surprise to the upside largely driven by politicians re-discovering the magic of fiscal spending. In today’s Special Report, we look at structural GICS1 sector-level implications for portfolio allocation courtesy of the looming inflationary flux, but with a major caveat. Over the years we have published numerous reports answering the question of “what to buy and what to sell” when inflation comes and goes. But, the key criticism is that our previous inflationary analysis included data from the current disinflationary era. In other words, the data was capturing the effects of reflation (i.e. inflationary spikes within the broader deflationary megatrend), rather than effects of the pure-play inflation (i.e. inflationary spikes within the broader inflationary trend). Up until recently, such analysis was well-fit for the macro environment investors were in, but given our structurally inflationary view, it pays to take a closer look at the relative GICS1 sector performance during “true” inflationary periods. The shaded areas in Chart 1 display five pure-play inflationary periods that we analyse in this Special Report. Importantly, we also treat the very first iteration with a big grain of salt as it was catalyzed by a one-off event: excessive Department of Defense (DoD) Vietnam War and Star War spending, which in turn skewed relative sector performance results (similarly to how relative sector performance during the recent pandemic-induced recession is not indicative of the typical recessionary sector performance). The Line In The Sand Before we proceed with our sectorial analysis, we must first distinguish between moves in core CPI that constitute deflation and inflation. We rely on empirical data and examine in detail the relationship between core CPI inflation, interest rates, and equites. Starting with equites, we find that the S&P 500 P/E multiple typically peaks when core CPI inflation reaches 2.3% and begins to decline once inflation climbs above 2.5% (Chart 2). At this level the market no longer finds the prospect of investing in long duration assets attractive. The investment horizon shortens as well as the multiple market participants are willing to pay for future earnings. The only adjustment we make to the 2.5% number is instead of looking at a specific inflection level, we turn it into a range of 2.3-2.7%. Chart 1True Inflationary Episodes True Inflationary Episodes True Inflationary Episodes Chart 2Inflation And The P/E Multiple Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Next, we bring fixed income into the picture and look at the correlation between SPX returns and changes in the 10-year US Treasury yield. The changes in this correlation help to distinguish between deflationary and inflationary environments due to different causality routes that exist from bonds to stocks, versus from stocks to bonds. A concrete example will help to clarify the point. When bond yields rise, they push stock prices down resulting into a negative causal correlation from yields to stocks. On the other hand, if stocks fall, then the central bank has to cut rates to protect the stock market, and in doing so it lowers yields. The end result is a positive causal correlation from stocks to yields. Negative correlation: yields rise ➜ DCF discount factor rises ➜ stocks fall Positive correlation: stocks fall ➜ central bank cuts rates ➜ yields fall Every central bank has to make the choice in which one of these two structural casual loops they operate as they can only protect one asset: either the bond market from inflation or the stock market from deflation. The choice of that key asset reveals the inflationary vs. deflationary regime. The bottom panel of Chart 3 illustrates this interplay. The top panel of Chart 3 also plots our 2.3%-2.7% inflation/deflation core CPI inflection range. Every time core CPI approached this critical range, the correlation between SPX returns and changes in the 10-year yield snapped to zero in preparation for a structural paradigm shift. This empirical exercise further illustrates that the 2.3-2.7% band in core CPI is the border between inflation and deflation. Chart 3The Border Line The Border Line The Border Line What follows is a select GICS1 sector return/positioning analysis during bouts of actual inflation. We also mainly focus on cyclical sectors since positioning within defensive GICS1 sectors is not driven by inflation, but instead it is dictated by global growth dynamics, which are beyond the scope of this Special Report.   Arseniy Urazov Senior Analyst ArseniyU@bcaresearch.com   Positioning For True Inflation: S&P Consumer Discretionary It is no secret that consumers don’t like CPI inflation as it erodes purchasing power via a multitude of channels. High interest rates that go toe to toe with inflation make big item purchases more challenging due to the higher cost of credit, hence weighing on end-demand for consumer discretionary stocks. Also, there is only so much cost pressures companies can pass onto the US consumer. The implication is that there comes a time when the entire S&P consumer discretionary sector is forced to sacrifice margins and profits. Chart 4 shows our consumer drag indicator that encapsulates both of these factors. Our thesis is that should true inflation return, the underperformance period is likely to be more severe compared with previous historical episodes (Chart 6). The reason for such a grim forecast has to do with the present-day sector composition. Following the inclusion of TSLA in this GICS1 sector, the combined exposure to AMZN and TSLA is 53% (Chart 5). Chart 4Inflationary Headwinds Inflationary Headwinds Inflationary Headwinds Chart 5Overconcentration Overconcentration Overconcentration Chart 6Inflation & Consumer Discretionary Equities Inflation & Consumer Discretionary Equities Inflation & Consumer Discretionary Equities Both of these companies are effectively a long duration trade, which disproportionately benefited from low rates via the multiple expansion channel. Should inflation return to the system and end the era of low rates, both TSLA and AMZN will fall out of investor’s favor and heavily weigh on the overall S&P consumer discretionary sector. Finally, the bottom panel of Chart 6 shows the impressive run consumer discretionary stocks had since the beginning of the millennium rising by over 100% in relative terms. The rise is also in sharp contrast to the performance from 1975 to 2000 when the sector was range bound. The implication is that should an inflation-induced normalization period take root, the risk/reward in the S&P consumer discretionary sector will lie to the downside. Bottom Line: The S&P consumer discretionary sector will underperform in an inflationary world. Positioning For True Inflation: S&P Financials Similar to their early cycle brethren consumer discretionary stocks, investors should shy away from financials when the inflation genie is out of the bottle. Outside of the anomaly Vietnam War/Moon Landing period, Chart 7 reveals that inflation is a major headwind for financials. Chart 7Inflation & Financials Equities Inflation & Financials Equities Inflation & Financials Equities There are several avenues through which it hurts the sector. The first one is the yield curve. When the Fed raises short term rates to combat inflation, it flattens the curve. The end result is that the yield curve is flatter during an inflationary era, meaning that the spread between borrowing and lending narrows for the banking sector and results in a net interest margins squeeze. As a result, profitability drops, and stock prices fall (Chart 7, bottom panel). Inflation also hurts S&P financials due to the mismatch between banks' assets and liabilities. A typical bank has longer maturity for its receipts stream than for its liabilities. Consequently, as inflation rises, it reduces the future net inflow because creditors demand higher interest rates, while the returns earned by the bank on its current loan book is mostly fixed by existing contracts. The net result is lower bank equity and subsequently lower stock prices. The example below adds more color to the argument. Table 1 shows a stylized example of a balance sheet for a commercial bank over the course of three years with the following assumptions: Table 1The Effect Of Inflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Inflation from Year 1 to Year 2 is 5%, but it increases from Year 2 to Year 3 to 10% The bank's contracts with creditors mature in 1 year, while loans mature in 2 years Reserve requirements against all deposits are 10% Nominal interest rates on loans stand at 5% Interest rates on deposits stand at 4.5% Cash account is ignored as it doesn’t affect qualitative results The bank starts in Year 1 and extends $1,000 worth of loans maturing in two years with a 5% rate and receives $1,000 worth of deposits that grow at 4.5% per year and mature next year. The bank also has 10% ($100) of its liabilities in reserves. The difference between assets and liabilities is the bank’s equity or market value, which is also $100. Next year, the bank receives $50 (5% of $1000) in income from the loans it extended in Year 1, but a portion of this income has to be moved to reserves as the value of deposits increased by $45 (4.5% of $1000). Thus, the final value of loans is $1050 minus ($45 times the 10% reserve requirement), which equals $1045.5. The bank’s nominal equity value also increased to $105, but when adjusted for inflation it remains the same as in Year 1. Now, expected inflation for Year 3 changes from 5% to 10%, and since deposits have matured, creditors renegotiate them at a new rate of 10%, while the loans that were issued in Year 1 remain contractually bind to the original 5%. Crunching the numbers for Year 3 using new interest rates reveals that both the nominal and real value of a bank’s equity decreased due to the maturity mismatch between its assets and liabilities. Of course, the bank could have extended new loans in Year 2 at the higher 10% rate, but it would have only reduced the drop in equity value, but not eliminated it, so for the sake of simplicity we ignored that option. What this exercise showed is the second avenue through which inflation weighs on banks, and by extension, financials equities. Bottom Line: It pays to shy away from the S&P financials sector during bouts of inflation. Positioning For True Inflation: S&P Energy The S&P energy index is a classic inflation beneficiary as true inflationary impulses are synonymous with oil price surges. Chart 8 highlights how this commodity-driven sector was quick to react to all six inflationary spurts, besting the market during each of them. Chart 8Inflation & Energy Equities Inflation & Energy Equities Inflation & Energy Equities Moreover, deglobalization is likely to provide a boost to relative energy prices over a multi-year time horizon as the number of proxy wars in South America and the Middle East will likely increase, undercutting global oil supply. Hence, the geopolitical risk premia in crude oil will also rise boosting the allure of energy stocks. Finally, for investors who are choosing between energy and materials equites to express their near-term inflationary view, we would recommend sticking to the S&P Energy index in light of our unfolding China slowing down view. Chart 9 also depicts how China's dominance in the materials market is nearly absolute compared to the one in energy space. Hence, materials equities are more sensitive to the China weakness story, and investors should at the margin prefer energy equities over materials. Stay tuned for an upcoming report that will explore this idea in greater depth and recommend a new intra-commodity complex pair trade. Bottom Line: The S&P energy sector will outperform the market should deflation recede. Chart 9China And Commodities China And Commodities China And Commodities   Positioning For True Inflation: S&P Industrials The S&P industrials sector is located in the middle of the economic value chain and thus it has diminishing power to pass on inflationary cost increases especially energy related ones. At the same time, capital goods producers have other corporations as their end-demand user, which means that they suffer less from inflation than sectors at the far end of the value chain like consumer discretionary. Chart 10 shows how relative performance of the S&P industrials sector is “neither here nor there” when examining inflationary spikes. Chart 10Inflation & Industrials Equities Inflation & Industrials Equities Inflation & Industrials Equities However, taking a closer look, we do note a shorter-term pattern that unfolds within every inflationary period. The S&P industrials index outperforms in the early stages of an inflationary spike, but then gives up its gains as inflation re-accelerates. There is an intuitive explanation for this dynamic. As deflation recedes giving way to inflation, industrial stocks are able to pass on the initial price increases to their customers thus preserving margins and profits. But as inflation persists, the fact that industrials companies are located in the middle of the economic value chain becomes a headwind as they are no longer able to pass on costs increases, which in turn gets reflected in falling relative stock prices. Bottom Line: Keep the S&P industrials index in the overweight basket early on into an inflationary spike, but do not overstay your welcome as inflation endures. Positioning For True Inflation: S&P Materials Typically, inflationary pressures first manifest themselves in higher raw material costs as rising demand from increased economic growth outpaces supply, benefiting materials equities. At the same time, the fact that materials stocks are the first link in the economic value chain allows them to efficiently pass on price increases, whereas other sectors at the end of the value chain like S&P consumer discretionary typically have the hardest time doing so (Chart 11). Chart 11Inflation & Materials Equities Inflation & Materials Equities Inflation & Materials Equities The current deflationary environment has proven rocky for the S&P materials sector as it sits at the second lowest level in history following the dotcom-formed “Mariana Trench”. Should our forecast for an inflationary revival prove accurate, materials producers will be prime beneficiaries with ample upside potential. The mean relative share price ratio during the previous inflationary cycle (1960-1996) is 0.25. Today, materials are sitting at the 0.12 mark, which makes a 100%+ rise a reasonable structural forecast. Bottom Line: Materials are a secular buy in an inflationary world. Positioning For True Inflation: S&P Technology On the surface, the S&P technology sector appears to be a textbook candidate to short during inflation, but empirical data disagrees with the theory. The top panel of Chart 12 shows that there have only been two clean periods when tech underperformed during true inflationary periods (1974-1976 and 1987-1990). On the other hand, in 1977 – the year that had a very significant inflationary spike – technology stocks managed to outpace the broad market by a wide margin. Chart 12Inflation & Technology Equities Inflation & Technology Equities Inflation & Technology Equities The reason for such inconsistent performance is due to the fact that the sector is sensitive to two opposing forces: multiple contraction and real economic growth. It is well-know that currently technology stocks represent the longest duration sector within the S&P 500, but they also enjoy inelastic demand profile. In other words, corporations cannot put their guard down and fully trim CAPEX and R&D expenses even during recessions because if they do, their competition will steam roll ahead. The same holds for the consumer sector. While some tech gadgets are luxury goods, consumers cannot simply postpone their PC, phone, and software related expenses as those are necessity goods. In short, the S&P technology index is not a pure-play cyclical sector as inelastic demand profile for its goods from other economic agents gives the sector some inflation-proof properties. Given that the upcoming inflationary impulse will be fiscal-driven, we would not rush to put tech stocks in the underweight basket. Instead, we opt to stick with a neutral allocation to underscore this tug of war effect between the two forces. Bottom Line: Relative technology performance in an inflationary world will depend on whether real economic growth can compensate for multiple contraction. Stick with a benchmark allocation. So What? In this Special Report we examined how investors should be positioned for true inflation rather than reflation. Some of the key differences are the following: financials switch from being a buy during reflation to a sell during true inflation, industrials are flat when looking at the entire inflationary spike, but they outperform in the early innings and underperform in the later stages of inflation, and finally technology is not a clear underperformer as this sector is caught between two opposing forces. Now circling back to our structural inflationary view, while it will take time for the current deflationary megatrend to make a full U-turn, the incoming post-recessionary spike driven by fiscal spending and heating up of the US economy will make for the right environment to test whether last century’s inflationary correlations will still hold. Our portfolio is appropriately positioned to test this hypothesis with an overweight toward inflationary winners and a neutral weight in inflationary losers (Table 2). As a reminder we have the S&P financials sector on downgrade alert. Table 2Current Portfolio Positioning Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation For completion purposes, Chart A1 in the Appendix on the next page also provides historical performance for defensive GICS1 sectors during true inflationary periods. Bottom Line: Investors should overweight true inflationary winners as the incoming CPI flux will unlock excellent value in those sectors.   Appendix Chart A1Appendix Appendix Appendix         Footnotes