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Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 17 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST and August 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Scheduling Note: There will be no US Bond Strategy report next week. The following week (August 31), clients will receive a report written by our Global Fixed Income Strategist Rob Robis. The regular US Bond Strategy publication schedule will resume on September 8 with the publication of September’s Portfolio Allocation Summary. Best regards, Ryan Swift, US Bond Strategist

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 5India’s Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 7India’s Importance As An Oil Client Has Been Rising The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 12India’s Appetite For Arms Imports Is Falling The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.

Highlights Fed: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Duration: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Labor Market: After July’s strong employment report, we calculate that average monthly nonfarm payroll growth of 431k is required to reach the Fed’s “maximum employment” liftoff criteria by the end of 2022. Feature Chart 1A Tapering Announcement Is Coming A Tapering Announcement Is Coming A Tapering Announcement Is Coming It’s finally time to talk about tapering. Several Fed governors and regional presidents made media appearances last week, each one presenting a timeline that sets up a tapering announcement before the end of this year. Federal Reserve Governor Christopher Waller: I think you could be ready to do an announcement by September. That depends on what the next two jobs reports do. If they come in as strong as the last one, then I think you have made the progress you need. If they don’t, then I think you are probably going to have to push things back a couple of months.1 St Louis Fed President James Bullard: I don’t think that we need to continue with these purchases now that we’ve got new risks on the horizon and possibly inflation risks on the horizon. […] What I think we should do here is start sooner and go faster and get finished by the end of the first quarter of next year. We don’t really need the purchases anymore.2 Dallas Fed President Robert Kaplan: As long as we continue to make progress in July (jobs) numbers and in August jobs numbers, I think we’d be better off to start adjusting these purchases soon. Doing so gradually, over a time frame of plus or minus about eight months, will help give ourselves as much flexibility as possible to be patient and be flexible on the fed funds rate.3 Fed Governor Lael Brainard presented the most detailed description of what it will take for the Fed to start paring its asset purchases.4 Since December, the Fed’s criteria for tapering has been “substantial further progress” toward its employment and price stability goals. In December, nonfarm payrolls were about 10 million below pre-pandemic levels (Chart 2A). In her speech, which was given prior to the release of July’s jobs report, Brainard noted that if employment grows at the same rate in Q3 as it did in Q2, then “about two-thirds of the outstanding job losses as of December 2020” would be made up by the end of 2021. That figure rose to 71% after July’s strong jobs number (Chart 2B). Chart 2AConditions For Tapering Conditions For Tapering Conditions For Tapering Chart 2BDefining "Substantial Further Progress" Defining "Substantial Further Progress" Defining "Substantial Further Progress" In other words, as long as employment growth stays solid – in the 500k/month range – then the Fed will be well over 50% of the way toward its maximum employment goal by the end of this year. This would certainly count as “substantial further progress”. Our expectation is that Q3 jobs growth will be strong enough for the Fed to make an official taper announcement in Q4, with the actual tapering starting in January 2022.5 There is an outside chance that the Fed will rush to start tapering earlier, but only if long-dated inflation expectations rise to well above the Fed’s target range (Chart 2A, bottom panel). As for market impact, we don’t expect the tapering announcement to move markets all that much. First, we mainly care about asset purchase tapering because it could signal that the Fed intends to move more quickly toward rate hikes (Chart 1). This is the concern that prompted the 2013 taper tantrum. This time around, however, the Fed has tied liftoff to explicit employment and inflation criteria. This forward guidance significantly weakens the signaling power of any tapering announcement. Second, surveys indicate that market participants already anticipate that tapering will start in early-2022 (Tables 1A & 1B). In other words, a Q4 taper announcement shouldn’t be that much of a shock to expectations. Table 1ASurvey Of Market Participants Expected Fed Timeline Talking About Tapering Talking About Tapering Table 1BSurvey Of Primary Dealers Expected Fed Timeline Talking About Tapering Talking About Tapering Interestingly, Fed Vice-Chair Richard Clarida did manage to shock markets with his speech last week, but only because he went further than just a discussion of tapering. Specifically, Clarida articulated his expected timeline for lifting interest rates: Chart 3Median FOMC Forecasts Median FOMC Forecasts Median FOMC Forecasts While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.6 What are the economic forecasts that Clarida says would meet the conditions for liftoff by the end of 2022? It turns out that they are very close to the FOMC’s median projections (Chart 3). The Fed’s forecast calls for 3% core PCE inflation in 2021, falling to 2.1% in 2022 and 2023. The Fed also sees the unemployment rate falling to 4.5% by the end of this year, 3.8% by the end of 2022 and 3.5% by the end of 2023. Clarida said that he views this forecast as consistent with overall employment returning to its pre-pandemic levels by the end of 2022. We think Clarida’s expected timeline is reasonable. The Appendix at the end of this report presents different scenarios for when the Fed’s “maximum employment” liftoff condition might be met. We estimate that average monthly nonfarm payroll growth of 431k will get us to maximum employment by the end of 2022, in time for early-2023 liftoff. At least so far, monthly nonfarm payroll growth is tracking well above the 431k threshold. If we compare our (and Clarida’s) forecast to market prices, we conclude that market rate expectations are too low. The overnight index swap curve is priced for Fed liftoff in January 2023 but for not even three 25 basis point rate hikes in total by the end of 2023 (Chart 4). This seems too low if the Fed’s liftoff criteria are in fact met by the end of 2022, as is our expectation. Chart 4Rate Expectations Rate Expectations Rate Expectations Bottom Line: The Fed is preparing markets for a taper announcement in Q4 of this year. But we don’t see asset purchase tapering as a catalyst for higher bond yields. Rather, bond yields will move higher as the employment data continue to come in hot. Job growth will be strong enough to reach the Fed’s definition of maximum employment by the end of 2022, and the fed funds rate will rise more quickly than is implied by current market expectations. Timing The Move Higher In Yields Our expectation for a return to maximum employment by the end of 2022 implies that bond yields will be significantly higher by then. Specifically, we expect that both the 5-year/5-year forward Treasury yield and the 10-year Treasury yield will be in a range between 2% and 2.25% by the time of the first rate hike (Chart 5). The 2% to 2.25% range is consistent with survey estimates of the long-run neutral fed funds rate. But a big question remains over the timing of the next move higher in yields. Are bond yields poised to jump higher immediately? Or will they remain low for the next few months and move up only in 2022? Our sense is that the catalyst for the next significant jump in bond yields will be surprisingly strong employment data. There is widespread consensus that inflation will be close to the Fed’s target (if not higher) by the end of 2022, but recent concerns about labor supply have increased the uncertainty around employment projections. Ultimately, we think that labor supply constraints will ease and that the unemployment rate will catch up to levels implied by different labor demand indicators (Chart 6). However, this may not happen during the next month or two. Chart 5A Target For Long-Dated Yields A Target For Long-Dated Yields A Target For Long-Dated Yields Chart 6Labor Demand Is Strong Labor Demand Is Strong Labor Demand Is Strong The spread of the Delta coronavirus variant has just started to ramp up in the United States (Chart 7). The UK’s experience with the variant shows that vaccination significantly limits the number of hospitalizations and suggests that economic lockdowns can be avoided. However, it took about one month for the UK’s new case count to peak once the variant started spreading. A similar roadmap could lead to hiring delays in the US during the next month or two, at least until the new case count starts to fall and concerns abate. From a market technical perspective, we also note that bond market positioning remains significantly net short and that bond market sentiment is less bullish than is often the case at major inflection points (Chart 8). This is not the ideal technical set-up for a large immediate jump in bond yields. Chart 7Delta Is A Near-Term Risk To Hiring Delta Is A Near-Term Risk To Hiring Delta Is A Near-Term Risk To Hiring Chart 8Positioning & Sentiment Positioning & Sentiment Positioning & Sentiment Bottom Line: The 10-year Treasury yield will reach a range of 2% to 2.25% by the time the Fed is ready to lift rates, near the end of 2022. Strong employment data will catalyze the next significant jump in bond yields, but this may not happen until Q4 of this year. The spread of the delta COVID variant could limit the pace of hiring during the next month or two, and bond market positioning may need to turn more bullish before yields can rise. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +431k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Talking About Tapering Talking About Tapering Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Talking About Tapering Talking About Tapering Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Talking About Tapering Talking About Tapering Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Talking About Tapering Talking About Tapering Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Table A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bloomberg.com/news/articles/2021-08-02/waller-says-strong-job-reports-may-warrant-september-taper-call?sref=Ij5V3tFi 2 https://www.stlouisfed.org/from-the-president/video-appearances/2021/bullard-washington-post-inflation-tapering 3 https://www.reuters.com/business/finance/exclusive-feds-kaplan-wants-bond-buying-taper-start-soon-be-gradual-2021-08-04/ 4 https://www.federalreserve.gov/newsevents/speech/brainard20210730a.htm 5 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021. 6 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Economy – A range of economic and fundamental indicators are at such high levels that deceleration is inevitable: US growth will peak any day if it hasn’t done so already. Markets – Financial markets typically pay closer heed to direction than level: All else equal, we prefer direction to level as well, but levels are likely to remain elevated for a while even as deceleration takes hold, and investors should take that into account when assessing the outlook. Strategy – Remain overweight equities and credit in multi-asset portfolios: Risk assets are likely to continue to generate positive excess returns over Treasuries and cash despite moderating growth. Feature COVID-19’s arrival ushered in a wave of extremes in monetary and fiscal policy measures, economic data and financial markets. Everywhere investors look, data series are at unusually outlying levels. Inflation pressures are more intense than they have been in decades, as measured by consumer price indexes and a range of business surveys. Household net worth has advanced at its fastest-ever five-quarter pace despite the record setback that began the pandemic, S&P 500 earnings growth has demolished analyst expectations over the last five quarters, the federal government has injected a head-spinning amount of fiscal stimulus into the economy and the Fed has done all it seemingly could to cushion the pandemic’s economic blow. Much of the growth has resulted from Herculean stimulus measures that cannot be maintained on a rate-of-change basis. The slowdown in fiscal and monetary thrust implies that economic growth, along with several other series that are viewed as significant financial market drivers, will soon peak if they haven’t already. The looming deceleration has kindled a recurring debate among BCA researchers: What matters most for financial markets, level or direction? The answer to the most challenging questions in markets and economics is often “it depends,” and that’s the way we view the level-versus-direction debate. We’d position a portfolio based on direction if key series were just breaking above or below trend levels with robust momentum, but it’s a more nuanced decision when they are slowing from exceedingly high levels and a modestly decelerating pace should have them still sitting well above trend this time next year. Our view, then, is that the interaction between level and direction will drive markets going forward. Given that we have cited a range of levels in support of our bullish stance, however, it is prudent to ask how good might be too good for reliably mean-reverting series. We therefore examine the empirical record of how S&P 500 returns have interacted with the level and direction of the unemployment rate, earnings-per-share growth, and interest rates. We conclude that the humble level matters as well as the more celebrated rate of change and that deceleration will not spell the end of the equity bull market. The Unemployment Rate We used the unemployment rate as a proxy for the impact of macroeconomic changes on S&P 500 returns. While the unemployment rate is quite variable from month to month, it tends to follow a clear pattern over longer periods of time, rising very rapidly to cyclical peaks before meandering its way to cyclical troughs. Over the series’ 73-year history, there have been eleven complete rising phases and it is currently in its eleventh declining phase (Chart 1). Owing to unemployment’s established pattern – it takes the elevator up and the stairs down, flipping equity indexes’ pattern on its head – the eleven rising phases have spanned 30% of the nearly 900 months while the falling phases currently total 70% of them. Chart 1Unemployment Takes The Elevator Up And The Stairs Down Unemployment Takes The Elevator Up And The Stairs Down Unemployment Takes The Elevator Up And The Stairs Down A simple compilation of one-month forward S&P 500 returns based on the level of the unemployment rate has a clear theme – stocks do well when the rate is at least one standard deviation above the mean (about 7.4% or higher) and poorly when it is one or more standard deviations below it (about 4.2% or lower) (Chart 2, left side). A compilation based on the month-to-month direction of the unemployment rate – up, down or unchanged – also favors rising unemployment, though it is unclear what investors should conclude from the fact that rising and falling both outperform unchanged (Chart 2, right side). Chart 2The S&P 500 Is Sensitive To Anticipated Turns In Unemployment Level Or Direction? Level Or Direction? We think the analysis is much improved if the unemployment rate is combined with its direction as indicated by the cycle phase. The interaction of level and phase provides more information than the simple message that high unemployment is good for equities and low unemployment is bad. Applying the rising or falling unemployment rate phase to the ranges shown in Chart 2, we find that direction matters quite a lot within four of the five ranges, where the annualized return differs by thirteen to sixteen percentage points based on the underlying trend (Table 1). Table 1Level And Direction Tell The Most Compelling Story Level Or Direction? Level Or Direction? Equities are just coming off their bottom, on balance, when the unemployment rate exceeds a standard deviation above its mean and is still rising. Direction is everything when the rate is below its mean (5.8%). When it’s falling, there’s plenty of money to be made in an expanding economy before the Fed has designs on removing the punch bowl, though once the rate is a standard deviation below the mean (4.2% or lower), the equity top is near. Once the unemployment rate rises off the bottom, even though it’s still at an unusually low level, the equity tide has already begun to go out. Losses are in store until the rate gets back above the mean, signaling future improvement. Chart 3Up, Up And Away Up, Up And Away Up, Up And Away It is important to recognize that we can only demarcate the unemployment rate’s phases in retrospect. There is no telling with certainty in real time how far a nascent trend will go. We do expect, however, in line with every FOMC voter, that the unemployment rate is likely to approach the vicinity of last cycle’s lows before the current phase ends. If that expectation is realized, there is a stretch of downward movement ahead (a good chunk of the 1.7% standard deviation, though July claimed 50 basis points of it) that has empirically been quite favorable for the S&P 500. The speed with which it covers the ground from here to 4% or below is unknown. Given the tremendous pent-up demand for labor, as evidenced by a record high job openings rate (Chart 3), the unemployment rate may come down much faster than it normally does. The level-and-direction analysis makes it clear that 5.9% and falling has provided an auspicious backdrop for equity investors, and the Fed’s more relaxed reaction function may allow the economy to run a little hotter than it normally would once unemployment falls below its natural rate. All in all, the empirical record of the relationship between the unemployment rate and equities suggests that stocks have room to run while the labor market improves. Earnings The unemployment rate may not be too low for equities to continue to rally, but is earnings growth too good for stocks’ own good? It doesn’t appear to be, given the historical interaction between forward one-quarter S&P 500 performance and the speed and acceleration of growth in trailing four-quarter earnings. We use trailing earnings because they exhibit extended trends that highly variable sequential changes in single-quarter data do not. Since 1948, trailing four-quarter operating earnings have experienced eleven complete double-digit declines from cycle peaks and eleven complete earnings growth phases, while beginning a new growth phase in the first quarter (Chart 4). Chart 4Steady Growth With Occasional Hiccups Steady Growth With Occasional Hiccups Steady Growth With Occasional Hiccups The chart shows that four-quarter earnings have grown in a pattern that features extended growth phases punctuated by concentrated declines that are occasionally severe. This pattern is the mirror image of the unemployment rate’s and S&P 500 earnings have been in a growth phase three out of every four quarters on the way to an annualized growth rate of 6.4%. Since P/E multiples are a mean-reverting series, stocks need to grow earnings to rise over time, but there is little difference in lagged S&P 500 returns when earnings are in growth or contraction mode (Chart 5). The disparity widens within each broad phase when we considered the growth rates – deceleration has been better for stock prices than acceleration within expansion phases, while a slowing rate of decline has been a tremendous catalyst when earnings are in a contraction phase. Chart 5More Money Is Made From Terrible To Bad Than From Good To Great Level Or Direction? Level Or Direction? To explore S&P 500 index performance during acceleration and deceleration phases within growth ranges, we repeated the unemployment rate analysis. The return disparities for different earnings ranges were not nearly as clear cut as they were for different unemployment ranges, but acceleration was good for near-term equity returns in the middle of the earnings growth distribution, while deceleration trumped acceleration at growth rates plus or minus three quarters of a standard deviation from the mean (Table 2). Table 2Headed Out Of The Earnings Sweet Spot Level Or Direction? Level Or Direction? The muddled empirical record does not point to a clear path for S&P 500 returns over the next few quarters. We assign a very low probability to a recession over the next year, virtually ensuring that the growth phase that began last quarter will continue. If actual earnings turn out to be somewhat close to the current consensus expectation, however, all subsequent quarters in this growth phase will be decelerating, and deceleration within growth phases (Table 2, circled three outcomes) has previously yielded below-average price returns. Trailing four-quarter earnings growth appears sustainable over the next year, however, and history is hardly sounding an alarm. Interest Rates We have already examined the relationship between moves in real 10-year Treasury yields and equity performance in a dedicated Special Report.1 The executive summary is that the level of real rates has exerted a greater influence on S&P 500 returns than their direction. The empirical evidence suggests that stocks generally outperform when real rates are rising, though they hit a wall once the real 10-yield exceeds estimated potential real GDP growth. They also underperform at the other extreme, as extremely negative real rates tend to be associated with dire economic conditions, but potentially frightening weakness is not a feature of today’s negative real-rate backdrop. Per the potential-GDP-rule-of-thumb, the nominal 10-year Treasury yield that would begin to crimp economic activity is around 4.5-5%, assuming potential GDP growth of 1.75-2% and annual inflation with a central tendency near 3%. It is very difficult to see the 10-year yield exceeding one-half of that threshold level in the next twelve months. Though a yield backup to 2% or above over the next year would likely have significant implications for relative returns within the S&P 500, we do not think it would spell the end of the equity rally. The bottom line, then, is that we do not believe that interest rates are at a level that makes equities especially vulnerable. Price-earnings multiples may well contract if real rates rise in line with our expectations, but we expect that earnings and earnings estimates would rise enough to offset the de-rating pressure. Investment Implications Mean reversion is a bedrock investment concept, and it helps explain why the level of variables that impact equity returns can be deceiving. When key variables reach extremes, the potential of an abrupt reversal increases. Financial markets are additionally forward discounting mechanisms and the rate of change – a variable’s “second derivative” – may offer more insight into its future path than its existing position. It is easy to see why investors typically favor direction over level when looking ahead. Level does not always take a back seat to direction, however, and we think a consideration of how level and direction interact is important when assessing the current landscape. Economic growth will surely slow from double or triple its long-run trend level, earnings will surely stop beating estimates by three or four times the maximum magnitude of the previous 32 quarters, nonfarm payrolls won’t expand by 900,000 every single month (though they may for much of the rest of this year) and a range of other variables won’t keep setting records. But deceleration from record highs will not necessarily spell the end of the rallies in risk assets. While important variables remain at elevated levels, equities and credit are likely to continue to generate excess returns. Extraordinary monetary and fiscal accommodation, combined with remarkably swift and successful action to blunt the threat of COVID-19, have carried financial markets for the last year-plus and we don’t think they’re finished yet. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 24, 2018 US Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?", available at usis.bcaresearch.com.

Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Hypo-Globalization Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware China Tech: Buyer Beware China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector China's Pain Threshold = Property Sector China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices Fertility Fell In Japan Despite Falling Prices Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out China Will Ease Policy... Or India Will Break Out China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Chart 13India Likely To Expand Fiscal Spending Soon Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Emerging Markets: Not Out Of The Woods Yet Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Dear Client, I will be on vacation next week. In lieu of our regular report, we will be sending you a Special Report written by my colleague Arthur Budaghyan, BCA Research’s Chief Emerging Markets Strategist. Arthur’s report will discuss the long-term outlook for industrial companies. He argues that the US is entering an industrial boom prompted by infrastructure stimulus and onshoring. This will benefit US industrial equities, or ones selling into the US on a multi-year horizon. I trust you will find it insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors keep asking whether the recent increase in US inflation is transitory. However, this is the wrong question to ask. Annualized core CPI inflation reached 10.6% in the second quarter. There is little doubt that inflation will fall from such elevated levels. The key question that investors should be asking is whether inflation will decline more or less than what the market is discounting. The widely watched 5-year/5-year forward TIPS inflation breakeven rate has sunk to 2.11%, below the Fed’s “comfort zone” of 2.3%-to-2.5%. Thus, the market already expects a substantial decline in inflation. Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. As inflation surprises on the upside, long-term bond yields will rise. This should revive bank shares and other reflationary plays. The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). The Right Question About Inflation Chart 1After A Spike In Q2, US Inflation Will Decelerate After A Spike In Q2, US Inflation Will Decelerate After A Spike In Q2, US Inflation Will Decelerate Investors remain focused on whether the recent bout of US inflation is transitory. However, this is not the correct question to be asking at the present juncture. The US core CPI rose by 10.6% at an annualized pace in Q2 relative to the first quarter (Chart 1). It is almost inevitable that inflation will come down from such high levels. The key question investors should be asking is whether inflation will decline more or less than what is already baked into market expectations. As Chart 2 shows, investors expect US inflation to come down rapidly over the next two years. The 5-year/5-year forward TIPS breakeven inflation rate – a good proxy for where investors expect inflation to be over the long haul – has sunk to 2.11% (Chart 3). This is below the Fed’s comfort zone of 2.3%-to-2.5%.1 Globally, long-term inflation expectations remain subdued (Chart 4). Chart 2Inflation Is Expected To Moderate Over The Coming Years Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 3Inflation Expectations Have Fallen Back Below The Fed's Target Zone Inflation Expectations Have Fallen Back Below The Fed's Target Zone Inflation Expectations Have Fallen Back Below The Fed's Target Zone Chart 4Long-Term Inflation Expectations Remain Subdued Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation       Inflation Will Fall, But… Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. Broad-based inflationary pressures would make the Fed nervous. However, that is not what we are seeing. Wages have accelerated markedly in only a few relatively low-skilled sectors such as retail trade and leisure and hospitality (Chart 5). For the economy as a whole, wage growth is broadly stable (Chart 6). The expiration of extended unemployment benefits, the reopening of schools, and increased immigration should also boost labor supply in the fall. Chart 5Faster Wage Growth Has Been Confined To A Few Low-Wage Sectors Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 6No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now     On the price front, more than two-thirds of the increase in the core CPI in June stemmed from pandemic-afflicted sectors (Chart 7). The price of the median item within the CPI index rose by just 2.2% year-over-year in June, somewhat below the pre-pandemic pace of inflation (Chart 8). Chart 7Most Of The Recent Increase In Inflation Is Pandemic-Related Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 8The Median Price In The CPI Basket Is Up Only 2.2% The Median Price In The CPI Basket Is Up Only 2.2% The Median Price In The CPI Basket Is Up Only 2.2% … Not As Fast As The Market Expects While inflation will fall as pandemic effects recede, investors are overestimating how fast this will happen. US growth has undoubtedly peaked, but at a very high level. Economists surveyed by Bloomberg estimate that US GDP rose by 9.0% in Q2. Growth is expected to slow to 7.1% in Q3 and 5.1% in Q4, while averaging 4.2% in 2022 (Table 1). By any standard, these are very strong, above-trend growth rates. Table 1Growth Is Peaking, But At A Very High Level Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 9Nearly 90% Of US Seniors Have Had At Least One Shot Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation The current Delta-variant wave is unlikely to slow US growth by very much. Although vaccination rates among younger people are at middling levels, they are quite high for the elderly who are most at risk of serious illness. Close to 89% of Americans above the age of 65 have received at least one shot, and nearly 80% are fully vaccinated (Chart 9). The 65+ age group accounts for four-fifths of all Covid deaths in the United States. Widespread vaccination coverage for older Americans will take pressure off the hospital system, allowing the economy to remain open. Fiscal Support In The US And Abroad As we noted last week, Senate Democrats are likely to use the reconciliation process to both raise the debt ceiling and pass President Biden’s $3.5 trillion American Jobs and Families Plan. They are also likely to move forward on Biden’s proposed $600 billion in infrastructure spending, with or without Republican support. Meanwhile, much of the fiscal stimulus that has already been undertaken has yet to make its way through to the economy. US households are sitting on about $2.5 trillion in excess savings, about half of which stems from increased government transfers (Chart 10). Chart 10A Lot Of Excess Savings Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 11Inventories Are At Low Levels Inventories Are At Low Levels Inventories Are At Low Levels   Satiating that demand has not been easy for many companies. Retail sector inventories are at record lows (Chart 11). The number of homes that have been authorized for construction but where building has yet to begin has increased by 62% since the start of the pandemic (Chart 12). By limiting production, supply-chain bottlenecks will push some spending towards the future. This will keep growth from decelerating more than it otherwise would. Outside the US, fiscal policy will remain supportive. All 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 13). Most of the money will be spent on public investment projects with high fiscal multipliers. Chart 12Growing Backlog Of New Home Construction Projects Growing Backlog Of New Home Construction Projects Growing Backlog Of New Home Construction Projects Chart 13EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 14Economic Growth In China Was Slow In H1 Economic Growth In China Was Slow In H1 Economic Growth In China Was Slow In H1 The Japanese government is contemplating sending stimulus checks to low-income citizens in advance of the general election due by October 22nd. It is an understandable move. Covid cases are rising again. As a result, the authorities have declared a state of emergency in Tokyo and barred spectators from attending the Olympic games in and around the city. Fortunately, the Japanese vaccination campaign has accelerated after a slow start. A third of the population has now received at least one shot. The government intends to vaccinate all eligible people by November.  Looking at quarter-over-quarter growth rates, Chinese growth averaged just 3.8% on an annualized basis in the first half of 2021 (Chart 14). Growth should pick up in the second half of the year thanks in part to increased fiscal spending. As of June, local governments had used only 28% of their annual bond issuance quotas, compared with 61% over the same period last year and 65% in 2019. Most of the proceeds from local government bond sales will likely flow into infrastructure projects.   Resumption Of The Dollar Bear Market Will Keep Inflation From Falling Too Far As a countercyclical currency, the US dollar usually weakens when global growth is strong (Chart 15). Short-term real interest rate differentials have moved sharply against the dollar, a trend that is unlikely to change anytime soon given the Fed’s dovish bias (Chart 16). While inflation in the US is not as sensitive to currency fluctuations as in most other countries, a weaker dollar will still lift tradeable goods prices (Chart 17). Chart 15The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 16Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Chart 17The Dollar And Inflation Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Structural Forces Turning More Inflationary Not only are cyclical forces likely to turn out to be less disinflationary than investors believe, but many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Chart 18Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 18). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over supply chains of essential goods. Baby boomers are leaving the labor force en masse. As a group, baby boomers hold more than half of US household wealth (Chart 19). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Despite a pandemic-induced bounce, underlying productivity growth remains anemic (Chart 20). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 21). Perhaps most importantly, policymakers are deliberately aiming to run the economy hot. A tight labor market will eventually lift wage growth to a greater degree than what we have seen so far (Chart 22). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Chart 19Baby Boomers Have Accumulated A Lot Of Wealth Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 20Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Chart 21Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step     Chart 22A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages Investment Implications Chart 23Positive Earnings Revisions Are At High Levels Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation The path to higher rates is lined with lower rates. The longer central banks keep interest rates below their neutral level, the more economies will overheat, and the more rates will eventually need to rise to bring inflation back down. For now, we are still in the warm-up phase to higher inflation. With long-term inflation expectations below target, central banks will be able to maintain accommodative monetary policies. This is good news for stocks, at least in the short-to-medium term. The recent wobble in equity markets has occurred despite a strong second quarter earnings season. According to the latest available data from I/B/E/S, 90% of S&P 500 companies have reported earnings above analyst expectations. Earnings have surprised on the upside by an average of 19.2%, compared to a historical average of 3.9%. Positive earnings revisions are at record high levels (Chart 23). Full year 2021 S&P 500 EPS estimates have risen 16% since the start of the year. Analysts have also raised their estimates for 2022 and 2023 (Chart 24). We continue to recommend that asset allocators favor stocks over bonds over a 12-month horizon.   Chart 24Analysts Have Been Revising Up Earnings Estimates This Year Analysts Have Been Revising Up Earnings Estimates This Year Analysts Have Been Revising Up Earnings Estimates This Year Chart 25The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth Chart 26Bank Shares Thrive In A Rising Yield Environment Bank Shares Thrive In A Rising Yield Environment Bank Shares Thrive In A Rising Yield Environment Tech stocks have outperformed the broader market over the past seven weeks. However, unlike during the pandemic, 12-month forward EPS estimates for tech have not risen in relation to other sectors (Chart 25). As long-term bond yields move back up, tech shares will underperform. In contrast, banks will benefit from higher yields (Chart 26).     Along the same lines, US stocks have outpaced other stock markets by more than one would have expected based on relative EPS trends. Notably, EM earnings have moved sideways versus the US since mid-2019. Yet, US stocks have outperformed EM by 17% over this period. Today, the forward P/E ratio for EM stands at 13.8, compared to 22.1 for the US (Chart 27). The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO).   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 27Wide Valuation Gap Between US And Non-US Markets Wide Valuation Gap Between US And Non-US Markets Wide Valuation Gap Between US And Non-US Markets Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Special Trade Recommendations Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Current MacroQuant Model Scores Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation

Highlights With geopolitical risks increasing around China, India is attracting greater attention from global investors. India’s youthful demographics also mark a stark contrast with China. While this demographic dividend is real, its benefits should not be overstated. India is young but socially complex, which will create unique social conflicts and policy risks. In particular, the country faces structurally large budget deficits. Regional political differences could slow down reforms. Lastly, competition with China will increase India’s own geopolitical risks. Macroeconomic and (geo)political factors, not youth alone, will determine India’s equity market returns. The bullish long-term view faces near-term challenges. Feature Map 1 PreviewIndia’s Demographic Dividend Can Be Overstated India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details “Independence had come to India like a kind of revolution; now there were many revolutions within that revolution … All over India scores of particularities that had been frozen by foreign rule, or by poverty or lack of opportunity or abjectness, had begun to flow again.” – Sir VS Naipaul, India: A Million Mutinies Now (Vintage, 1990) What is well known is that India is populous, young, and boasts a high GDP growth rate. India is also largely free of internal conflicts. Its democratic framework is seen as a pressure valve that can release social tensions. India’s hefty 58% cross-cycle premium to Emerging Markets (EM) is often attributed to the fact that India is younger than its peers, especially China. In this report we highlight that India’s demographic advantage is real but should not be overstated. For instance, India’s northern region can be likened to a demographic tinderbox. It accounts for about 45% of India’s population and is also younger than the national average. However, per capita incomes in this region are lower than the national average and to complicate matters, this region is crisscrossed by several social fault lines. This heterogeneity and economic backwardness in India’s population is the reason why the trend-line of India’s demographic dividend will not be linear. Its diverse population’s attempt to break out of its poverty will spawn unique policy risks. The North Is A Demographic Tinderbox, The South Is Prosperous But Ageing India will soon be the most populous country in the world (Chart 1). India’s median age is a decade lower than that of China to boot (Chart 2). Some emerging market investors fret about India’s low per capita income but India holds the promise of lifting individual incomes over time. This is because its GDP growth rate has been higher than that of its peers (Chart 3). Chart 1India Will Soon Be The Most Populous Country India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 2India Is A Decade Younger Than China India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 3India’s Per Capita Income Is Low, But GDP Growth Rate Is High India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details However, the “demographic dividend” narrative oversimplifies India’s investment case. India is young but also socially heterogenous and its median voter is poor. This complicates India’s development process and makes its demographic dividend trend-line non-linear. India’s social complexity is best understood if India is characterized as an amalgamation of three major regions: the North, the South (which we define to include the western region), and the East. Each of these parts are unique and have distinctive socio-demographic identities. India hence is more comparable to a continent like Europe than a country like the US. Like the European Union, India is a union of multiple social, religious, and ethnic groups. It straddles a vast geography and represents a very wide spectrum of interests. India’s South is more like a middle-income Asian country such as Sri Lanka or Vietnam whilst India’s East is more like a poor Latin American economy with latent social unrest. Understanding the heterogeneity of India’s vast populace is key to get a better sense of why an investment strategy for India must be nuanced and tactical in its approach, even if the overarching strategic view is constructive. The key features of each of these three regions can be summarized as follows: Region #1: The North This region comprises the triangular area between Jammu & Kashmir, Rajasthan and Jharkhand. This is the largest landmass in India stretching from the Himalayas to the fertile Gangetic plains of central India. Ethnically most of the population here is of Indo-Aryan descent. A lion’s share of this region’s population remains engaged in agriculture and allied activities. The North accounts for about 45% of the nation’s total population and is a demographic tinderbox. Per capita incomes are low and one in five persons falls in the age group of 15-24 years. To complicate matters, wage inflation in the farm sector, which employs a large majority of the populace in this region, has been slowing. If job creation in the non-farm sector stays insufficient then it will fan fires of social instability. The North includes states like Uttar Pradesh and Punjab which have seen a steady increase in small but notable socio-political conflicts in the recent past. Issues that triggered social conflict ranged from inter-religious marriages to resistance to amending farmer-friendly laws. Region #2: The South India’s South constitutes the large inverted-triangular region on the map and spans the area between Gujarat, Kerala, and West Bengal. We include India’s western region in this category because of its socio-economic similarities with the southern peninsula. Together the South and West account for the entirety of India’s peninsular coastline and for about 40% of total population. Historically, the South has seen far fewer external invasions and its social fabric is more homogenous than that of the North. This region is characterized by high per capita incomes, balanced gender ratios (Chart 4), and higher literacy ratios (Chart 5). Socio-political conflicts in this region are less common as compared to the North. Chart 4India’s South Has Healthy Gender Ratios Compared To North India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 5India’s South Is More Educated Than The Rest Of India India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details The state of Kerala is an exception in this region. The social fabric in this state is unusual, with Hindus accounting for only 55% of its population (versus the national average of 80%). The high degree of religious heterogeneity in this southern Indian state could perhaps be the reason why the state has lately seen a rise of small but significant incidences of social conflict. Unlike India’s young North, the median age of the population in India’s South is likely to be higher than the national average. Whilst India’s South is clearly young by global standards, this region will have to deal with problems of an ageing population before India’s North or East. The Southern region in India even today relies on migrant workers from India’s North. Region #3: The East This region is the youngest and the smallest of the three, as it accounts for the remaining 15% of India’s population. The region is young but must contend with low per capita incomes and very high degrees of religious diversity. Muslims, Christians, and other religions account for 20% of India’s population nationally but +50% of the population in India’s East. By virtue of sharing borders with countries like Bangladesh, Nepal, and Myanmar, this region is often the entry point for migration into India. It is historically the least stable of the three regions owing to its heterogeneity and the steady influx of migrants. To conclude, India is young but is also socially complex. Whilst a youthful population yields economic advantages, if this young population lacks economic opportunity then social dissatisfaction and associated risks can be a problem. Furthermore, history suggests that if a region’s populace is young but poor and diverse, then it often spawns the rise of identity politics, which takes policymakers’ attention away from matters of economic development. Social Complexity Index To better represent India’s demographic granularities, we created a Social Complexity Index (SCI), as shown in Map 1. Map 1India’s North Is A Demographic Tinderbox; South Is Prosperous But Ageing India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details The SCI for Indian states is created by adding a layer of socio-economic data over the demographic data. It uses three sets of variables: Economic well-being of a state as proxied by state-level per capita incomes. The lower the incomes, the greater the risk of social instability. This is because India’s per capita income is low to start with and if pockets have incomes that are substantially lower than the national average then the associated economic duress can be significant. Religious diversity in a state as measured by creating a Herfindahl-Hirschman Index of religious diversity in the state. The greater the religious diversity the greater the social complexity is expected to be. Youthfulness of a state as measured by population in the age group of 15-24 years relative to the total population. The greater the youth population ratio, the more complex are the social realities likely to be. If a state is exposed unfavorably to all three of the above stated parameters then such a state is deemed to have a high degree of social complexity and hence could be exposed to a higher risk of social conflicts and/or policy risks. Our Social Complexity Index (SCI) (Map 1) shows how parts of India are young but also socially complex. Why does this matter? This matters because a diverse, young and vast population’s attempt to develop will create policy risks. Policy Impact: Left-Leaning Economics, Right-Leaning Politics To be sure, governments in India will stay focused on creating large-scale jobs, a big concern for India’s median voter (Chart 6). However, given the time involved in building consensus for any major reform, progress on economic reforms (and hence job creation) will remain slow. India’s large population and democratic framework render the reform process more acceptable, but also less nimble. This contrasts with the speed of reforms executed by East Asian countries in the 1970s-90s, which turned them into export powerhouses. Two recent examples illustrate the problem of slow reform in India: Implementation of GST: Goods and services tax (GST) was a major reform that India embraced in 2017. However, the creation of a nation-wide GST was first mooted in 2000 and it took seventeen years for this reform to pass into law. Even in its current form India’s GST does not cover all products. It excludes large categories like petroleum products and electricity owing to resistance from state governments. Industrial sector growth: Despite India’s consistent efforts to grow its industrial sector as a source of large-scale, low-skill jobs, the share of this sector in India’s GDP has remained static for three decades (Chart 7). The services sector has grown rapidly in India over this period but its ability to absorb low-skill workers on a large scale is fundamentally restricted since (1) the sector needs mid-to-high skill workers and (2) the sector generates fewer jobs per unit of GDP owing to high degrees of productivity in the sector. Chart 6India’s Median Voter Worries Greatly About Job Creation India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 7India’s Industrial Sector Stuck In A Rut, India’s Workforce Is Connected And Aware India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details India’s inability to reform rapidly and create jobs on a large-scale will trigger policy risks. This factor is more relevant now than ever. In the 1990s, India was a small, closed economy that was just opening up. Hence slow reforms were acceptable as they yielded high growth off a low base. By contrast India’s masses today are at the forefront of connectivity (Chart 7). Slow job growth in a young country with high degrees of connectivity will have to be managed in the short term by responding to other needs of India’s median voter. This process might delay painful structural reforms necessary to improve productivity and hence create policy risks in the interim. What policy-risks is India exposed to? We highlight three policy risks that investors must brace for: Policy Risk #1: Structurally Large Budget Deficits Despite being young, India’s fiscal deficit has been large and as such comparable to that of countries that have an older demographic profile (Chart 8). Chart 8Despite India’s Youth, Its Fiscal Deficit Has Been Comparable To That Of Older Countries India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 9Unlike China, The Majority Of India’s Citizenry Lives On Less Than US$10 A Day India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Whilst India’s fiscal deficit will rise and fall cyclically, it will remain elevated on a structural basis as India’s median voter is young but poor (Chart 9). This median voter will keep needing government support to tide over her economic duress. These fiscal transfers are likely to assume the form of transfer payments, food subsidies and a large interest burden on the exchequer who will need to borrow funds in the absence of adequate tax revenue growth. Two manifestations of this fiscal quagmire that India must contend with include: Revenue expenditure for India’s central government accounts for 85% of its total expenditure, with only 15% being set aside for more productive capital expenditure. Within central government revenue expenditure, 40% is foreclosed by food-subsidies, transfer payments, and interest payments. Can India’s fiscal deficit be expected to structurally trend lower? Only if India embraces big-ticket tax reforms. This appears unlikely given that India’s central tax revenue to GDP ratio has remained static at 10% of GDP for two decades owing to its inability to widen its tax base. Policy Risk #2: Foreign Policy Will Turn Rightwards India’s northern states are known to harbor unfavorable views of Pakistan. These are more unfavorable than the rest of India (Map 2). Geopolitical tension will persist due to a confluence of factors. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details India may be forced to adopt a far more aggressive foreign policy response and shed its historical stance of neutrality. This will be done to respond to tectonic shifts in geopolitics as well as the preferences of India’s north that accounts for about 45% of India’s population. China’s active involvement in South Asia will accentuate this phenomenon whereby India tilts towards abandoning its historical foreign policy stance of non-alignment. An aggressive foreign policy stance will engender fiscal costs as well as diverting attention away from internal reform. The adoption of a more aggressive foreign policy stance will necessitate the maintenance of high defense spending when these scarce resources could be used for boosting productivity through spends on soft as well as hard infrastructure. Despite having low per capita incomes, India already is the third largest military spender globally. In 2022, India’s central government plans to allocate ~15% of its budget for defense, which is the same allocation that productivity-enhancing capital expenditure as a whole will attract. Since it will be politically untenable to cut social spending, defense spending will simply add to the budget deficit. Policy Risk #3: Regional Differences Could Get Amplified Over Time India’s northern states typically lag on human development indicators (Charts 4 and 5). Owing to their large population, these states have also lagged smaller states in the east more recently on vaccination rates, which could be a symptom of deeper problems of managing public services in highly populous states (Chart 10). Chart 10India’s Northern States Lagging On Vaccinations, Smaller Eastern States Are Leading India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Whilst such differences between India’s more populous and less populous states are commonplace, these tensions could grow over the next few years. In specific, it is worth noting that a delimitation exercise in India is due in 2026. Delimitation refers to the process of redrawing boundaries for Lok Sabha seats to reflect changes in population. India’s Northern states are likely to receive an increased allocation of seats in India’s lower house (i.e. the Lok Sabha) beginning in 2026, despite poor performance on human development indicators. This is because India’s North accounted for 40% of seats in India’s lower house and accounted for 41% of its population in 1991. Owing rapid population growth, this region’s population share rose to 44% by 2011 and the ratio could rise further. Given that a review of the allocation of Lok Sabha seats is due in 2026, it is highly likely that India’s northern states get allocated more seats at this review. A change in political influence of different regions will have two sets of implications. Firstly, reforms that require a buy-in from all Indian states (such as GST implementation in 2017) could become trickier to implement if states that have delivered improvements in human development have to contend with a decline in political influence. Secondly, the rising political influence of India’s more populous states in the North could reinforce the trend of a less neutral and more aggressive foreign policy stance that we expect India to assume. Investment Conclusions Indian equity markets have historically traded at a hefty premium to Emerging Markets (EMs). This premium is often attributed to India’s youthful demographic structure. However academic literature has shown that realizing benefits associated with a youthful demographic structure is dependent on a country’s institutions and requires the productive employment of potential workers. It has also been shown, both theoretically and empirically, that there is nothing automatic about the link from demographic change to economic growth.1 Country-specific studies have also shown that it is difficult to find a robust relationship between asset returns on stocks, bonds, or bills, and a country’s age structure.2 An analysis of equity market returns generated by young EMs confirms that a youthful demographic structure can aid high equity returns but the geopolitical setting and macroeconomic factors matter too. Moreover, history confirms that each young country spawns a new generation of winners and losers. Fixed patterns in terms of top performing or worst performing sectors are not seen across young and populous EMs. The rest of this section highlights details pertaining to these two findings. Investment Implication#1: Youth Does Not Assure High Equity Market Returns China in the nineties, Indonesia & Brazil in the early noughties and India over the last decade had similar demographic features (see Row 1, 2 and 3 in Table 1). Table 1Leader And Laggard Sectors Can Vary Across Young, Populous Countries India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details However, it is worth noting that these four EMs delivered widely varying returns even when their demographic features were similar (see Row 5, 6 and 7 in Table 1). In real dollarized terms equity returns ranged from a CAGR of -22% to 8% for these four countries. The variation in returns can be attributed to differences in macroeconomic and geopolitical factors. Brazil’s period of political stability in the early 2000s along with its relatively high per capita incomes were potentially responsible for Brazil’s youthful demography translating into high equity market returns. At the other end of the spectrum, equity returns in China were the lowest despite a young demography owing to low per capita incomes and economic restructuring prevalent in the nineties. Investment Implication#2: Each Young Country Spawns A New Generation Of Winners And Losers Given that a young populace is expected to display a higher propensity to consume, sectors like consumer staples, consumer discretionary, and financials are expected to outperform in young countries. However, a cross-country analysis suggests that a young country does not necessarily throw up any consistent patterns of sector performance. Sectoral performance patterns too appear to be affected by demographics along with macroeconomic and geopolitical factors. Similarities in the profile of top performing sectors in India, China, Brazil and Indonesia when these countries were young are few and far between (see Row 9, 10 and 11 in Table 1). No patterns or similarities are evident even in the profile of worst performing sectors in India, China, Brazil and Indonesia when they had similar demographic features (see Row 12, 13 and 14 in Table 1). Even India’s own experience confirms that: There exists no correlation between India’s equity market returns and its demographic structure. India was at its youngest in the nineties and yet its peak equity market returns were achieved in the subsequent decade (see Row 4, 5 & 6 in Table 2). High domestic growth combined with the emergence of political stability potentially allowed India’s youth to translate into high equity market returns over 2000-2010. Table 2Youth Is Not A Sufficient Condition For A Market To Deliver High Returns India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details There exists no pattern in terms of top or worst performing sectors in India as it has aged over the last three decades (see Row 8 to 13 in Table 2). Healthcare for instance was the top performing sector in India in the 1990s when India’s median age was only 21 years. Industrials as a sector have featured as one of the worst performing sectors in India in the 1990s as well as the late noughties despite India’s youthful age structure. This could be attributed to the fact that India’s growth model pivoted off service sector growth while industrial sector development has lagged. Bottom Line: History suggests that a youthful demographic structure is a necessary but not a sufficient condition for an emerging market like India to deliver high equity market returns. Besides demographics, domestic macroeconomic and regional geopolitical factors create a deep imprint on equity returns’ patterns too. India faces a geopolitical tailwind as its economy develops and China’s risks increase. Nevertheless, owing to India’s heterogeneity and poverty, its road to realizing its demographic dividend will be paved with policy risks. Even as India’s lead on the demographic front is expected to continue, tactical underweights on this EM too are warranted from time to time.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 David Bloom et al, "Global demographic change: dimensions and economic significance", NBER Working Paper No. 10817, September 2004, nber.org. 2 James M Poterba, "Demographic Structure and Asset Returns" The Review of Economics and Statistics, Vol. 83, No. 4, November 2001, The MIT Press.

Highlights Duration: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. Stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, we expect the 10-year Treasury yield to reach a range of 2% to 2.25% by the end of 2022 when the Fed is ready to lift rates. Maintain below-benchmark portfolio duration. Employment: The static unemployment rate and sub-50 readings from ISM employment indexes will prove to be short-lived phenomena driven by labor supply constraints. These constraints will vanish in the fall when schools re-open and expanded unemployment benefits lapse. Yield Curve: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Feature Last week was another dramatic one in the bond market. Bond yields fell sharply as doubts emerged about the pace of economic recovery and the economy’s progress back to full employment. The 10-year Treasury yield started the week at 1.44% before hitting an intra-day low of 1.25% on Thursday. It then rebounded somewhat to end the week at 1.36%. One catalyst for the move was Tuesday morning’s ISM Non-Manufacturing report that printed at 60.1, below consensus expectations of 63.5. But in truth, economic momentum had already been slowing for several months before that release. The 10-year Treasury yield peaked at 1.74% on March 31st, right around the same time that the New York Fed’s Weekly Economic Index and both the ISM Manufacturing and Non-Manufacturing indexes leveled-off (Chart 1). Last week simply saw the “slowing growth” narrative pick up steam. One noteworthy feature of last week’s market action is that the Treasury curve flattened as yields fell. While the 10-year yield is now at its lowest since February, the 2-year yield remains higher than it was just prior to the June FOMC meeting (Chart 2). This suggests that part of the drop in long-maturity bond yields is due to a fear that the Fed will over-tighten in the face of slowing growth. This fear likely stems from the Fed’s apparent hawkish pivot at the June FOMC meeting.1 Chart 1"Peak Growth" Hits The Bond Market "Peak Growth" Hits The Bond Market "Peak Growth" Hits The Bond Market Chart 2A Flatter Curve Since March A Flatter Curve Since March A Flatter Curve Since March   It’s also worth mentioning that the bulk of last week’s drop in yields was concentrated in long-maturity real yields (Chart 2, bottom 2 panels). TIPS breakeven inflation rates have fallen somewhat since the end of March. But, at 2.3% and 2.23% respectively, the 10-year and 30-year TIPS breakeven inflation rates are not that far below the Fed’s 2.3% - 2.5% target range. Chart 3Bond Rally Not Confirmed By Commodities Bond Rally Not Confirmed By Commodities Bond Rally Not Confirmed By Commodities Finally, many have suggested that “technical factors” are responsible for last week’s bond market strength. That is, factors related to the supply and demand for bonds but unrelated to economic fundamentals conspired to push yields lower. This is a difficult thesis to prove or disprove, but we will point out that the 10-year Treasury yield has diverged significantly from the CRB Raw Industrials / Gold ratio (Chart 3). The 10-year yield and the CRB/Gold ratio tend to track each other very closely but, in contrast to yields, the CRB/Gold ratio has actually increased since March 31st. This lends some credence to the argument that last week’s drop in yields is not purely a reflection of economic weakness, and it could be an overreaction to weaker-than-expected data that was exacerbated by extreme short positioning in the market (Chart 3, bottom panel). Three Reasons Why The Decline In Treasury Yields Is Overdone We do in fact think that the recent decline in Treasury yields is overdone, and we continue to see the 10-year Treasury yield reaching a range of 2% - 2.25% by the end of next year when the Fed is ready to lift rates. We present three reasons why the recent drop in Treasury yields is overdone. First, the bond market is making too much of the “slowing growth” narrative. Yes, it’s certainly true that the economic indicators shown in Chart 1 are no longer accelerating, but in level terms they remain consistent with a robust economic recovery where GDP growth is well above trend. This sort of growth environment is consistent with a falling unemployment rate that will eventually bring Fed rate hikes into play. Bond yields will move higher as this tightening cycle approaches. Second, it is not just the pace of economic growth that matters for bond yields. The output gap matters as well.2 That is, the same rate of economic growth will coincide with higher bond yields when the unemployment rate is 5% than it will when the unemployment rate is 10%. With that in mind, we observe that the output gap has closed significantly during the past year. The prime-age employment-to-population ratio is 77%, up from a 2020 low of 70%. Similarly, capacity utilization is 75%, up from a 2020 low of 64% (Chart 4). Unless we expect economic growth to slow enough for progress on these two fronts to reverse, then we should see significantly higher bond yields this year compared to last year. This makes it difficult to see how Treasury yields can fall much further from current levels. Another way to conceptualize the relationship between the output gap and long-maturity bond yields is to look at how long-dated yields move relative to short-dated yields. Since the Fed moves the funds rate in response to changes in the output gap, we can model the 10-year Treasury yield relative to the fed funds rate and expectations for near-term changes in the fed funds rate to get a sense of how well the output gap explains changes in long-maturity bond yields. Chart 5 presents a simple model of the 10-year Treasury yield relative to the fed funds rate and the 24-month fed funds discounter. It shows that last week’s decline in the 10-year yield caused it to diverge significantly from the model’s fair value. Chart 4The Output Gap Matters The Output Gap Matters The Output Gap Matters Chart 5Long-Maturity Yields Are Too Low Long-Maturity Yields Are Too Low Long-Maturity Yields Are Too Low   Third, the Fed’s pledge to keep rates at the zero-lower-bound at least until the labor market reaches “maximum employment” means that the labor market outlook is critical for bond yields. Our view is that the labor market is on the cusp of a rapid recovery that will cause the Fed to lift rates before the end of 2022. However, recent labor market data have been mixed and there is considerable uncertainty in the market about the future pace of employment gains. The next section delves deeper into the outlook for the labor market. Making Sense Of The Employment Data Chart 6ISM Employment Below 50 ... ISM Employment Below 50 ... ISM Employment Below 50 ... Overall, it seems safe to say that the labor market data have been disappointing in recent months. Yes, nonfarm payroll growth has averaged a robust +543k this year, but the minutes of the June FOMC meeting revealed that “some participants” viewed employment gains as “weaker than they had expected”. The recent dips in the employment components of both the ISM Manufacturing and Non-Manufacturing indexes to below the 50 boom/bust line only add to the sense of pessimism about the labor market. Historically, sub-50 readings from the ISM employment indices (particularly from the non-manufacturing ISM) have coincided with slowing employment growth (Chart 6). This time, however, we don’t see the ISM employment indexes staying below 50 for very long. The more demand-focused components of the ISM indexes – production, new orders and backlog of orders – remain elevated (Chart 7). This tells us that demand is strong and that hiring is only weak because of labor supply constraints, a topic we have covered repeatedly in this publication.3 Our view is that by September, once schools re-open and expanded unemployment benefits lapse, we will see a surge in hiring and a jump in the ISM employment components as people are enticed back into the workforce. A clearer picture of the labor market will then emerge, and it will catalyze a jump in bond yields. It’s not just weak ISM employment readings that are giving investors doubts about the labor market. The unemployment rate’s decline has also slowed markedly in recent months (Chart 8). Our adjusted measure of the U3 unemployment rate currently sits at 6.1%, above the headline U3 measure of 5.9% and significantly above the range of 3.5% to 4.5% that the Fed estimates is consistent with full employment. Chart 7... But Demand Indicators Are Elevated ... But Demand Indicators Are Elevated ... But Demand Indicators Are Elevated Chart 8Slow Progress On Unemployment Slow Progress On Unemployment Slow Progress On Unemployment Chart 9Labor Supply Is The Problem Labor Supply Is The Problem Labor Supply Is The Problem We adjust the U3 unemployment rate to include a number of people that are currently being classified as “employed but absent from work” when they should be classified as “temporarily unemployed”. The number of people describing themselves as “employed but absent from work” jumped sharply in March 2020 and has remained elevated. This is the result of workers that were placed on temporary furlough during the pandemic and who should be counted as unemployed. We make our adjustment by taking the difference between the number of people that are “employed but absent from work for other reasons” each month and a baseline calculated as that month’s average between 2015 and 2019. We then add this excess amount to the number of temporarily unemployed. This gives us adjusted readings for both the U3 unemployment rate and the temporary unemployment rate (Chart 8, top 2 panels). The Appendix of this report updates our scenarios for the average monthly nonfarm payroll growth required to reach “maximum employment” to consider both this new adjustment and June’s employment figures. Technical adjustments aside, the main takeaway for investors is that progress toward “maximum employment” has been relatively slow during the past few months. This is particularly true if we look at the unemployment rate excluding those on temporary furlough (Chart 8, panel 3) and the labor force participation rate (Chart 8, bottom panel). This slow progress toward “maximum employment” is undoubtedly a reason why bond yields remain low. But, once again, we think it’s only a matter of time before labor supply constraints ease and the unemployment rate falls rapidly, catching up to indicators of labor demand that have already surpassed pre-COVID levels (Chart 9). Bottom Line: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. The labor market also continues to make progress toward maximum employment (and Fed rate hikes) though that progress has slowed during the past few months. We anticipate that stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, the economy will reach full employment in time for the Fed to lift rates in 2022. We expect that the 10-year Treasury yield will be in a range of 2% to 2.25% by then. Maintain below-benchmark portfolio duration. A Quick Note On The Yield Curve Chart 105y5y Still Close To Fair Value 5y5y Still Close To Fair Value 5y5y Still Close To Fair Value While we view the recent drop in the level of bond yields as an overreaction, we are less inclined to view recent curve flattening as temporary. To see why, let’s look at the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate. We like to think of the 5-year/5-year forward Treasury yield as a market proxy for the long-run neutral fed funds rate, so a range of estimates of that rate is a logical fair value target. The 5-year/5-year forward Treasury yield has fallen a lot during the past few weeks. But, at 2%, it is still within the range of neutral rate estimates from the New York Fed’s Survey of Market Participants and only just outside of the same range from the Survey of Primary Dealers (Chart 10). The fact that the 5-year/5-year yield remains relatively close to its fair value range tells us that there is very limited scope for curve steepening. Recent periods of significant curve steepening have tended to coincide with one of the following two developments: The Fed is cutting rates (coincides with a bull-steepening) The 5-year/5-year forward Treasury yield moves into its fair value range after starting out well below it (coincides with a bear-steepening) This second sort of curve steepening occurred during the 2013 taper tantrum, after the 2016 presidential election and again after the 2020 presidential election. It’s conceivable that the yield curve could re-steepen somewhat during the next few months, if the 5-year/5-year forward yield moves back to its prior highs. But we expect the next major move in the Treasury market to be a bear-flattening as the rest of the yield curve catches up to the 5-year/5-year. This is the sort of curve flattening that occurred in 2017 and 2018 when the Fed was lifting rates (Chart 10, bottom 2 panels). A bear-flattening of the yield curve is also the most likely outcome if we start to see significant positive employment surprises later this year, as we anticipate. These employment surprises would bring forward the timing and pace of rate hikes but wouldn’t necessarily cause investors to question their views about the long-run neutral fed funds rate. Bottom Line: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +484k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Overreaction Overreaction Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Overreaction Overreaction Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Overreaction Overreaction Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Overreaction Overreaction Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart helps us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 For a description of the five macro factors that determine bond yields please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019. 3 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021.   Fixed Income Sector Performance Recommended Portfolio Specification