Monetary Policy

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? (Part 2)’. I do hope you can join. Highlights If a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel the pain. We reiterate that the pain point at which the Fed would be forced to volte-face is only around 30 bps away on the 30-year T-bond, equal to a yield of around 2.4-2.5 percent. That would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds, or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. Chinese long-duration bond yields are on a structural downtrend. Fractal analysis: The Korean won is oversold. Feature Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned about the trebling of the crude oil price since March 2020? Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders, by driving up the bond yield and tipping an already fragile market and economy over the brink. Today, could oil become the accessory to another murder? (Chart I-1) Chart I-1AOil Was The Accessory To The Murder In 2008... Oil Was The Accessory To The Murder In 2008... Oil Was The Accessory To The Murder In 2008... Chart I-1B...Could It Become The Accessory To Another Murder? ...Could It Become The Accessory To Another Murder? ...Could It Become The Accessory To Another Murder?   Oil Is The Accessory To Many Murders Turn the clock back to the 1970s, and it might seem more straightforward that the recession of 1974 was the direct result of the oil shock that preceded it. Yet even in this case, we can argue that oil was the accessory, rather than the true culprit of that murder. It is correct that the specific timing, magnitude, and nature of OPEC supply cutbacks were closely related to geopolitical events – especially the US support for Israel in the Arab-Israeli war of October 1973. Yet as neat and popular as this explanation is, it ignores a bigger economic story: the collapse in August 1971 of the Bretton Woods ‘pseudo gold standard’, which severed the fixed link between the US dollar and quantities of commodities. To maintain the real value of oil, the OPEC countries were raising the price of crude oil well before October 1973. Meaning that while geopolitical events may have influenced the precise timing and magnitude of price hikes, OPEC countries were just ‘staying even’ with the collapsing real value of the US dollar, in which oil was priced. Seen in this light, the true culprit of the recession was the collapse of the Bretton Woods system, and the oil price surge through 1973-74 was just the accessory to the murder (Chart I-2). Chart I-2In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar In 1973-74, OPEC Was Just 'Staying Even' With A Collapsing Real Value Of The Dollar A quarter of a century later in 1999, the oil price again trebled within a short time span – and by the turn of the millennium, the ensuing inflationary fears had pushed up the 10-year T-bond yield from 4.5 percent to almost 7 percent (Chart I-3). With stocks already looking expensive versus bonds, it was this increase in the bond yield – rather than a decline in the equity earnings yield – that inflated the equity bubble to its bursting point in early 2000 (Chart I-4). Chart I-3In 1999, As Oil Surged, So Did The Bond Yield... In 1999, As Oil Surged, So Did The Bond Yield... In 1999, As Oil Surged, So Did The Bond Yield... Chart I-4...Making Expensive Equities Even More Expensive ...Making Expensive Equities Even More Expensive ...Making Expensive Equities Even More Expensive To repeat, for the broader equity market, the last stage of the bubble was not so much that stocks became more expensive in absolute terms (the earnings yield was just moving sideways). Rather, stock valuations worsened markedly relative to sharply higher bond yields. Seen in this light, the oil price surge through 1999 was once again the accessory to the murder. Eight years later in 2007-08, the oil price once again trebled with Brent crude reaching an all-time high of $146 per barrel in July 2008. Again, the inflationary fears forced the 10-year T-bond yield to increase, from 3.25 percent to 4.25 percent during the early summer of 2008 (Chart I-5) – even though the Federal Reserve was slashing the Fed funds rate in the face of an escalating financial crisis (Chart I-6). Chart I-5In 2008, As Oil Surged, So Did The Bond Yield... In 2008, As Oil Surged, So Did The Bond Yield... In 2008, As Oil Surged, So Did The Bond Yield... Chart I-6...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis ...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis ...Even Though The Fed Was Slashing Rates In The Face Of A Financial Crisis Suffice to say, driving up bond yields in the summer of 2008 – in the face of the Fed’s aggressive rate cuts and a global financial system teetering on the brink – was not the smartest thing that the bond market could do. On the other hand, neither could it override its Pavlovian fears of the oil price trebling. Seen in this light, the oil price surge through 2007-08 was once again the accessory to the murder. Inflationary Fears May Once Again Lead To Murder Fast forward to today, and the danger of the recent trebling of the oil price comes not from the oil price per se. Instead, just as in 2000 and 2008, the danger comes from its potential to drive up bond yields, which can tip more systemically important economic and financial fragilities over the brink. One such fragility is the extreme sensitivity of highly-valued growth stocks to the 30-year T-bond yield, as explained in The Fed’s ‘Pain Point’ Is Only 30 Basis Points Away. On this note, one encouragement is that while shorter duration yields have risen sharply through October, the much more important 30-year T-bond yield has just gone sideways. A much bigger systemic fragility lies in the $300 trillion global real estate market, as explained in The Real Risk Is Real Estate (Part 2). Specifically, the global real estate market has undergone an unprecedented ten-year boom in which prices have doubled in every corner of the world. Over the same period, rents have risen by just 30 percent, which has depressed the global rental yield to an all-time low of 2.5 percent. Structurally depressed rental yields are justified by structurally depressed 30-year bond yields. Therefore, any sustained rise in 30-year bond yields risks undermining the foundations of the $300 trillion global real estate market (Chart I-7). Chart I-7Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Structurally Depressed Rental Yields Are Justified By Structurally Depressed 30-Year Bond Yields Nowhere is this truer than in China, where prime real estate yields in the major cities are at a paltry 1 percent. In this context, the recent woes of real estate developer Evergrande are just the ‘canary in the coalmine’ warning of an extremely fragile Chinese real estate sector. This will put downward pressure on China’s long-duration bond yields. As my colleague, BCA China strategist, Jing Sima, points out, “Chinese long-duration bond yields are on a structural downtrend…yields are likely to move structurally to a lower bound.” But it is not just in China. Real estate is at record high valuations everywhere and contingent on no major rise in long-duration bond yields. In the US, there is a tight relationship between the (inverted) 30-year bond yield and mortgage applications for home purchase (Chart I-8), and a tight relationship between mortgage applications for home purchase and building permits (Chart I-9). Thereby, higher bond yields threaten not only real estate prices. They also threaten the act of building itself, an important swing factor in economic activity. Chart I-8The Bond Yield Drives Mortgage Applications... The Bond Yield Drives Mortgage Applications... The Bond Yield Drives Mortgage Applications... Chart I-9...And Mortgage Applications Drive Building Permits ...And Mortgage Applications Drive Building Permits ...And Mortgage Applications Drive Building Permits To repeat, focus on the 30-year T-bond yield – as this is the most significant driver for both growth stock valuations, and for real estate valuations and activity. To repeat also, the 30-year T-bond yield has been generally well-behaved over the past few months. But if a continued surge in the oil price – or other commodity or goods prices – started driving up the 30-year T-bond yield, the markets and the economy would feel pain. And at some point, this pain would force the Fed to volte-face. We reiterate that this pain point is only around 30 bps away, equal to a yield on 30-year T-bond of around 2.4-2.5 percent – a level that would be a great buying opportunity for bonds. Given the proximity of this pain point, it is too late to short bonds or for equity investors to rotate into value and cyclical equity sectors. That tactical opportunity has almost played out. On a 6-month and longer horizon, equity investors should prefer long-duration defensive sectors such as healthcare. The Korean Won Is Oversold Finally, in this week’s fractal analysis, we note that the Korean won is oversold – specifically versus the Chinese yuan on the 130-day fractal structure of that cross (Chart I-10). Chart I-10The Korean Won Is Oversold The Korean Won Is Oversold The Korean Won Is Oversold Given that previous instances of such fragility have reliably indicated trend changes, this week’s recommended trade is long KRW/CNY, setting the profit target and symmetrical stop-loss at 2 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Having worked as an economist for close to 50 years, the current strange and uncertain environment seems a good time to look back and consider some of the lessons I have learned. An additional reason for writing this rather personal report is that, after 34 exciting and interesting years, I will retire from BCA at the end of this month. Over the ages, there has been an insatiable demand for predictions – seeking those who are believed to have a window into the future, whether it be the Oracle of Delphi or the proverbial guru on the mountaintop. Surely, someone somewhere must know what is going to happen? Unfortunately, my almost half century in the forecasting business has highlighted that the future is essentially unknowable, and I have not come across anyone with a consistently good track record. Fortunately, all is not lost because forecasting errors can be minimized by following some basic rules and practices. Dealing With Shocks Chart 1My First Forecasting Shock My First Forecasting Shock My First Forecasting Shock My career as an economist began in January 1973 when I joined the Forecasting Division within the Corporate Planning Department of British Petroleum in London. At the time, this seemed a strange move to friends who had entered the booming financial sector. The oil industry was regarded as incredibly dull with the crude price averaging $2.50 a barrel during the previous five years and no expectations of a major change in the foreseeable future (Chart 1). Of course, industry experts did not foresee the October 1973 war in the Middle East and OPEC’s resulting embargo of oil deliveries to the US. The crude price spiked above $15 a barrel in early 1974 and remained in double digits even after the embargo ended. This was my first lesson in the power of unforeseen shocks to destroy the basis of current forecasts and force a complete rethink of the outlook. A problem in dealing with major shocks is that some are transitory (e.g. natural disasters such as Japan’s devastating Fukushima earthquake) and some reflect a structural shift in the outlook. The oil shock was clearly in the latter category. OPEC suddenly became aware of its power to influence the market and from that time on, it took a more aggressive role in setting prices. At BP, long-run planning could not assume a return to pre-1974 prices and that was a game changer. In practice, most shocks are transitory, even if it is not evident at the time. And I believe that is true of the Covid-19 pandemic. Even if the virus cannot be eradicated, treatments will improve and we will learn to live with it, just as we live with the common cold and seasonal flu. There may be a lasting impact on some areas such as increased working from home, but I am skeptical that there will be any major change to the underlying drivers of economic growth. At most, it may encourage some trends that are already underway. However, the extreme policy response to the crisis will have some important effects and I will return to that later. Catching Structural Shifts Many economists spend much of their time making detailed economic forecasts for the coming one and two years. That may have great value in helping firms plan production schedules but is of limited value in helping investors time the market. As I have noted in previous reports, economists have done a poor job of forecasting recessions, which is the most important thing to get right from a planning point of view. Table 1 shows the recession forecasting record of the Federal Reserve, an institution that has tremendous economic brainpower and resources at its disposal. The Fed staff failed to predict any of the recessions in the past 50 years and other official and private sector forecasters were no better. Table 1Fed Economic Forecasts vs. Outcomes Perspectives From A Long Career Perspectives From A Long Career BCA has wisely eschewed short-term economic forecasts. You would never read in a BCA publication a statement such as “we have revised next year’s GDP growth from 3.2% to 2.7%”. That does not mean we don’t care about the short-run economic outlook: we believe it is necessary to have a view about whether the consensus on economic trends is likely to be disappointed - either on the upside or downside. However, it is more important to focus on catching the long-term structural shifts in economic trends. Looking back over the past 50 years, the most important economic development for investors to get right was the rising inflation of the 1970s and its subsequent multi-decade decline. Any investors smart enough to be on the right side of the long-run inflation cycle would have avoided stocks and bonds and embraced commodities in the 1970s and done the reverse thereafter. While BCA’s track record was not perfect, it generally was on the right side of these trends. Another long-run trend that investors needed to identify was the surge in global trade and interdependence, beginning in the 1990s as former-communist countries and China embraced more market-friendly policies. This not only reinforced global disinflation but also shifted economic power from labor to capital, driving profit margins to record levels. Chart 2The Retreat From Globalization The Retreat From Globalization The Retreat From Globalization Turning to the current environment, another structural shift is underway. Several years ago, we noted that the tide was turning against globalization. This showed up in a decline in cross-border capital flows, political and popular antipathy to large-scale immigration, and a flattening in the ratio of global trade to production (Chart 2). Recent developments have exacerbated these trends. Notably, the Covid-related disruptions to supply chains has forced a rethink about the wisdom of relying so heavily on foreign production facilities. The shift away from globalization is likely to persist for some time. This will support the case for a structural increase in inflation, a development underpinned by other forces. For example, the pendulum is swinging away from capital back to labor, central banks are setting themselves up to stay too easy for too long and crushing public sector debt burdens will make policymakers more willing to tolerate inflation overshoots. A structural increase in inflation (albeit nowhere near 1970’s levels) means that investors should expect a further decline in profit margins, higher interest rates and gains in inflation hedges. This will be a gradual shift with price pressures likely to moderate in the coming year as supply chain disruptions ease. Ignore Monetary Policy At Your Peril The level of interest rates is the single most important driver of asset prices which means that investors must pay close attention to central bank policy. During my career I have had a lot of contact with central bankers, not least because I was fortunate enough to attend the Federal Reserve’s Jackson Hole symposium for 18 years. Central bankers tend to be treated with great professional reverence. Every statement is examined for nuances about their views and there seems to be an implicit assumption that superior access to information and market intelligence gives them an edge when it comes to understanding economic trends and developments. Sadly, this is not the case. My many discussions with senior policymakers have made it abundantly clear that regarding the big questions about the outlook, they are no better placed than the rest of us. For example, like forecasters in general, they are struggling to know whether the recent rise in inflation is temporary, when supply chain disruptions will end and what will happen to resource prices. This is rather disconcerting as it would be desirable if those twiddling the policy dials were more informed than us outside observers. Chart 3Low Rates Underpin the Bull Market Low Rates Underpin the Bull Market Low Rates Underpin the Bull Market Regardless of whether policymakers fully understand the long-run implications of their policies, the actions of central bankers have major market effects. One might reasonably have thought that the adverse economic impact of the pandemic would seriously damage the stock market, but the hit was short-lived with the MSCI All-Country Index currently 27% above its end-2019 level and close to its all-time high. This can be attributed to the fact that short-term interest rates in the major developed economies have been kept close to zero for more than a year (Chart 3). In 1852, the eminent financial journalist Walter Bagehot famously quipped that “John Bull can stand many things, but he can’t stand 2%”. In other words, a world of low interest rates is anathema to investors, forcing them to take greater risks in order to secure higher returns. What was true then remains true today. Low rates have driven investors into stocks as an explicit objective of central bank policy. Chart 4Inflation Undershoots For Two Decades Inflation Undershoots For Two Decades Inflation Undershoots For Two Decades In the 1960s and 1970s, central bankers erred by keeping policy too easy for too long. Their formative years as policymakers were in the earlier decades when deflation was seen as a much bigger threat than inflation. This dulled their perception about the inflation risks of their policies. In contrast, the policymakers in charge during the 1980s to 2000s were fiercely anti-inflationary as they had experienced the inflationary consequences of their predecessors. Now the pendulum has swung back again because inflation has underperformed central bank expectations for the past 20 years, a period that also saw some severe deflationary shocks (Chart 4). In other words, the scene is setting up again for policy errors on the side of too much monetary stimulus and higher inflation. The high inflation of the 1970s was grim for financial assets with both equities and bonds delivering negative real returns. Bond investors underestimated the persistence and level of inflation which means they accepted ex-ante negative real yields. On the equity side, higher inflation did tremendous damage to corporate finances because of rising costs and the failure of companies to set aside enough for depreciation. Inflation accounting did not exist in those days and corporate restructuring had yet to occur. There is now much more awareness of inflation risks and accounting is better. Thus, inflation will be much less damaging to equities than before. However, we have returned to negative bond yields, largely as a result of policy-imposed financial repression rather than investor complacency. In other words, a new inflation cycle likely will be more damaging to bonds than stocks. What About Debt? On joining BCA, I had to learn about “The Debt Supercycle”, a term the company developed in the 1970s to describe the role of policy in feeding a seemingly never-ending cycle of increased leverage, resulting financial vulnerability and ever-desperate measures by policymakers to keep things afloat. This was well highlighted by the Fed’s response to the bursting of the tech bubble in the early 2000s when it kept interest rates at historically low rates even as the economy recovered. This helped create the conditions for the subsequent debt-driven housing bubble which led to an even greater policy response when that blew up in 2007-08. The essential message from BCA’s Debt Supercycle thesis is that investors should never underestimate the lengths to which policymakers will go to keep the economic/financial ship afloat. The Debt Supercycle primarily referred to the trend in private sector indebtedness in the US, although it applied to other countries. For example, in 2012, ECB President Mario Draghi noted that he was prepared “to do whatever it takes to preserve the euro”. Chart 5A Shift in the Debt Supercycle A Shift in the Debt Supercycle A Shift in the Debt Supercycle To all intents, the financial crisis of 2007-09 effectively ended the private sector Debt Supercyle in the US. Despite keeping interest rates at extremely low levels, the Fed has been unable to trigger a new upturn to household sector leverage (Chart 5). Corporate debt burdens have risen, but largely for financial engineering purposes (equity buybacks and M&A) rather than capital spending. With the private sector no longer willing or able to go on another debt-fueled spending spree, the public sector has had to take its place. The past decade has witnessed an unprecedented peacetime increase in government deficits and debt. Inevitably, the surge in government debt has fueled bearish predictions of looming financial disaster. However, the same lessons apply regarding private sector excesses: the authorities will go to extreme lengths to prevent financial and economic chaos. The solution to excessive government debt is not to pursue even greater fiscal stimulus. Instead, the solution will be a mix of financial repression, higher inflation and eventually renewed fiscal discipline. That will not rule out periodic crises to force necessary policy actions, but investors should not assume that current high levels of government debt will inevitably lead to financial Armageddon. I apologize if that sounds complacent and I know that our long-standing client Mr. X would take a very different view. Who Is Mr. X? I have been asked countless times over the years whether Mr. X is a real person and, if so, who he is. I have always refused to answer this question, just as Coca Cola Inc. would never reveal the recipe for its drink. After all, it’s interesting to have a little mystery in an otherwise strait-laced business. What I can say is that our end-year conversations with Mr. X have proved invaluable in clarifying our thinking as we prepare our Annual Outlook report. It highlights the need to avoid groupthink and take account of a wide range of views. Mr. X is an interesting character in that he views the world through an Austrian School perspective. This means he favors free market solutions over aggressive policy interventions and has a healthy distrust of both politicians and central bankers. He does not like debt and fears inflation. All this has given him a bearish bias toward risk assets over the past few decades and it has been a perpetual struggle for us to convince him to adopt a more pro-growth investment strategy. That said, he was correctly more bearish than us in late 2007 and while we were not optimistic at that time, we should have paid more attention to his views. We recently held our annual discussion with Mr. X, along with his daughter Ms. X who joined his family office a couple of years ago. She does not share his Austrian School perspective and is much more inclined to take risks, given her hedge fund background. You will discover their latest thinking in our new Outlook report, due to be published next month. Timing The Markets The Bank Credit Analyst began publication in 1949 and it was years ahead of its time in understanding the role of money and credit in driving the economy and asset markets. Its founder, Hamilton Bolton, developed a series of monetary indicators that enabled him to make very prescient market calls and that is what put the company on the map. The focused monetary approach worked very well until the end of the 1970s because banks were the dominant financial intermediary, creating a relatively stable and predictable relationship between trends in money and the financial markets. It all changed with financial deregulation and innovation, beginning in the 1980s. BCA’s monetary indicators no longer worked so well, and we had to adopt a more comprehensive approach. Timing the markets is as much art as science but I would make the following observations: The stance of monetary policy remains the most important factor to consider, despite the less stable relationship between money flows and markets. Current negative real interest rates at a time when the economy is expanding are a powerful incentive to favor risk assets. Valuation is poor indicator of near-run trends. As Keynes famously noted “the stock market can stay irrational longer than you can remain solvent”. I learned that painful lesson in the late 1990s when I advocated caution in the Bank Credit Analyst yet the markets marched ever higher, until they finally broke in early 2000. Not a happy time! Yet, there is a well-established correlation between starting valuations and long-run returns so they cannot be completely ignored (Chart 6). Chart 6Valuation Matters for Long-Run Returns Perspectives From A Long Career Perspectives From A Long Career Chart 7Technicals Still Positive For Stocks Technicals Still Positive For Stocks Technicals Still Positive For Stocks Technical indicators can provide useful information around major turning points, although they are prone to false signals. Investor sentiment typically is at a bullish extreme at market tops and vice versa at bottoms. Also, I remember reading a large tome that reviewed every technical indicator known to man and it concluded that the most reliable one was the humble moving average crossover. Following a simple rule such as acting when the index crosses its 200-day average will keep you out of the market for the bulk of a bear phase and in for the bulk of a bull run. Of course, by definition, it will be a bit late and there will be many whipsaws. Currently, the stock market is above its rising 200-day average and investor sentiment is far from a bullish extreme (Chart 7). Don’t base your market expectations on consensus forecasts for the economy. The economy is a lagging not leading indicator of the markets. However, if your economic view is very different from the consensus, then that should impact your strategy. The bottom line is that there is no magic solution to consistently successful market timing. This explains why 86% of US active equity managers underperformed the benchmark index over the past 10 years, according to S&P Dow Jones data.1 At BCA, we follow a disciplined comprehensive approach that has served us well over the years, but inevitably we also suffer the occasional wobble. Concluding Thoughts Within BCA I have developed a reputation of being the resident bear and that does not bother me at all. It suits my Scottish temperament (probably weather-related), and anyway, I think it is more fun to be bearish. The language of the dark side is very rich and descriptive and it is not a surprise that bad news sells more newspapers than good news. To be bullish when there always are many problems around just makes one sound complacent and out-of-touch. Of course, it is important to get the markets right and I would never take a bearish view just to be different. In practice, I have generally been positive on risk assets, but that has not stopped me from pointing out the downside risks along the way. Perhaps, I have spent too much time talking to Mr. X! I have had much to be thankful for during my career. It has been a great privilege to interact with so many very smart and interesting people and a constantly changing economic and financial environment has kept me fully engaged. Whenever I was foolish enough to think I had things figured out, events taught me otherwise. I may be leaving BCA but will continue to follow economic and market developments with keen interest.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com mhbarnes15@gmail.com   Footnotes 1Detailed data on the performance of active managers are available at https://www.spglobal.com/spdji/en/research-insights/spiva/

Highlights Gold prices will continue to be challenged by conflicting information flows regarding US monetary policy; higher inflationary impulses from commodity prices and supply-chain bottlenecks; global economic policy uncertainty, and risks to EM economic growth (Chart of the Week). Concern over the likely tapering of the Fed's asset-purchase program this year, rate hikes next year and fiscal-policy uncertainty will support rising interest-rate risk premia and a stronger USD. These will remain headwinds for gold. Going into the Northern Hemisphere's winter, risk premia in fossil-fuel prices are at or close to their zeniths, as is the Bloomberg commodity index. This will keep short-term inflation elevated. Heightened geopolitical tensions – particularly between Western democracies and China – will keep the USD well bid by risk-averse investors. The commodity-induced element of PCEPI inflation will be transitory. Uncertainty over US monetary policy and rising geopolitical tensions, however, will remain part and parcel of gold fundamentals indefinitely. The trailing stop on our long 1Q22 natural gas call spread – long $5.00/MMBtu call vs. short $5.50/MMBtu call – was elected, leaving us with a 20% gain. We will not be re-setting the spread at tonight's close, due to the difficulty in taking a price view in markets with extremely high weather-related uncertainty. Feature The quality of information informing the analysis of gold markets is highly uncertain at present. US monetary policy uncertainty and the future of Fed chairman Jerome Powell keep expectations twitchy when it comes issues like the tapering of the Fed's asset-purchase program. Our colleagues at BCA's US Bond Strategy expect the Fed will announce a taper in asset purchases by November 2021 which will end in June 2022.1 But the tapering really is not, in our estimation, as big a deal as inflation and inflation expectations, which will drive the Fed's rate-hiking timetable. Chart of the WeekUncertainty Weighs On Gold Uncertainty Weighs On Gold Uncertainty Weighs On Gold The first Fed rate hike expected by our bond desk likely will come at the end of next year. Our colleagues expect the Fed will want to check off three criteria before increasing interest rates (Table 1). The inflation targets – actual and expected – already have been checked off, leaving the labor market's recovery as the only outstanding issue on our internal checklist. By December 2022, once the maximum employment criterion has been met, the Fed will commence with rate hike.2 Subsequent rate hikes will depend on inflation expectations. Table 1A Checklist For Liftoff Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold Uncertain Inflation Expectations The higher inflation that checks off our bond desk's list resulted from COVID-19-impacted services and tight auto markets (Chart 2). We also find evidence commodities feed into inflation expectations and realized inflation, both of which are key variables for the Fed (Chart 3). Transitory effects – chiefly supply-chain bottlenecks and a global scramble for coal, gas and oil – have lifted realized inflation in 2H21, and have taken the Bloomberg commodity index to record levels (Chart 4). Nonetheless, given the fundamental backdrop for the key industrial commodities – chiefly oil, gas, coal and base metals – the inflationary impulse from commodity markets could persist indefinitely into the future, in our estimation. In order to incentivize the investment in base metals needed to literally build out the renewable energy infrastructure, the grids that support it and the electric vehicles that will supplant internal-combustion-engine technology, higher energy and metals prices will be required for years.3 This will be occurring as the production of traditional energy sources – i.e., fossil fuels – winds down due to lower investment over the next 10-20 years. This also will result in higher and more volatile oil and gas prices. Chart 2Inflation Meets Fed Targets Inflation Meets Fed Targets Inflation Meets Fed Targets Chart 3Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations Commodities Feed Into Inflation Expectations All of these real-economy factors will feed into higher inflation over time, which will present the Fed with difficult choices regarding monetary policy and interest rates. Chart 4Record Commodity Index Levels Record Commodity Index Levels Record Commodity Index Levels USD Strength Suppresses Inflation And Gold Prices  It is worthwhile noting the current USD strength is suppressing inflation. However, it is not suppressing commodity prices entirely, as Chart 4 shows. The transitory weather-related price increases in energy commodities will pass, either when winter ends or if a less severe winter hits the Northern Hemisphere. We continue to expect a lower dollar, as the Fed's accommodative monetary policy remains in place. Even after the Fed tapers its asset-purchase program, policy will remain loose. The large fiscal packages that most likely will be approved by the US Congress will swell the US debt and budget deficits, which likely will weaken the USD over time. On a purchasing-power-parity basis (PPP) we also expect a weaker dollar (Chart 5). We also are expecting the availability of more efficacious vaccines in EM economies to boost economic activity, which will strengthen incomes and local currencies vis-à-vis the USD. Chart 5Weaker USD Expected On A PPP Basis Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold The risk to this USD view – which would support gold prices – remains the heightened geopolitical tensions between Western democracies and China, which will keep political uncertainty elevated and will keep the USD well bid by risk-averse investors. Persistent USD strength would restrain inflation, and weaken the case for owning gold. Investment Implications We remain bullish gold over the medium- and long-term, expecting higher inflation and inflation expectations to lift demand for this safe haven. However, persistent commodity-induced inflation could force the Fed to tighten monetary policy more than is currently expected to get out ahead of higher inflation and inflation expectations. This could lead to stagflation, wherein inflation runs high but growth stalls as interest rates move higher. Persistent geopolitical risk also will keep risk-averse investors well bid for the USD. Commodities Round-Up Energy: Bullish First-line US natural gas prices were down ~ 9% as we went to press, following reports Russia would make more gas available to European buyers. This report apparently was later contradicted by a Gazprom official, who said Russian inventories still were being filled ahead of winter.4 WTI crude oil prices came close to hitting a seven-year high early in the trading day Wednesday, then promptly retreated (Chart 6). The news flow is indicative of the extreme sensitivity of gas and oil buyers going into the coming winter. Base Metals: Bullish Earlier this week, the Peruvian government struck an deal with MMG Ltd, owner of the Las Bambas mine, and the local community around the site, which reportedly will involve hiring local residents to provide services to the mine, including helping transport minerals and maintaining key transit roads. The community had been protesting to seek more of the income from the mine, and created blockades en route to the site, which threatened ~ 2% of global copper supply. Peru's newly elected president, TK Castillo, rose to power on the promise to redistribute mining wealth to Peruvian citizens. This was his first negotiation with a mining company since his election in July. MMG’s major shareholder is China Minmetals Corp. The Leftist president will need to balance the interests of local stakeholders on the one hand, while ensuring the world’s second largest copper producing nation is still attractive to international miners. Precious Metals: Bullish In 2021, the World Platinum Investment Council expects the platinum to swing to a physical surplus of 190k oz, which reverses an earlier forecast for a deficit made in the Council's 1Q21 report (Chart 7). Demand is forecast to increase year-over-year, spurred by increases in automotive, industrial and jewelry demand. On the supply side, growth in South Africa's mined output growth will keep markets in a surplus for 2021. According to SFA Oxford, gross palladium demand and refined supply for 2021 are expected to be at 10.03mm oz, and 6.77mm, respectively. Palladium balances (ex-ETFs) are projected to remain in a physical deficit of 495k ounces for 2021. Chart 6 WTI LEVEL GOING UP WTI LEVEL GOING UP Chart 7 Conflicting Signals Challenge Gold Conflicting Signals Challenge Gold   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Footnotes 1     Please see Damage Assessment, published by BCA Research's US Bond Strategy on September 28, 2021. 2     Please see 2022 Will Be All About Inflation, published by BCA Research's US Bond Strategy on September 14, 2021, which notes the concept of maximum employment is not a well-defined term. 3    Please see La Niña And The Energy Transition, which we published last week. 4    Please see Energy price surge sends shivers through markets as Europe looks to Russia published by reuters.com on September 6, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Highlights The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Consumer complaints of “poor buying conditions” mean that higher prices will cause demand destruction. Hence, it is extremely dangerous for central banks to respond with the signalling of tighter policy that leads to higher bond yields. The upper limit to the 10-year T-bond yield is no higher than 1.8 percent. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary versus the market, given the very tight connection between weaker spending on durables and the underperformance of the goods dominated consumer discretionary sector. Commodities whose prices have not yet corrected are at much greater risk than those whose prices have corrected. Hence a new cyclical recommendation is to go underweight tin versus iron ore. Fractal analysis: Netflix versus Activision Blizzard, and AUD/NZD. Feature Chart of the Week"Buying Conditions Are Poor" "Buying Conditions Are Poor" "Buying Conditions Are Poor" The current burst of inflation in developed economies is due to a (negative) supply shock rather than a (positive) demand shock. Getting this diagnosis right is crucial, because responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. Responding to supply shock generated inflation with tighter monetary policy is extremely dangerous. The current burst of inflation cannot be due to a demand shock. If it was, aggregate demand would be surging. But it is not. For example, in the US, both consumer spending and income lie precisely on their pre-pandemic trend (Chart I-2). Furthermore, consumers are complaining that high prices for household durables, homes, and cars have caused “the poorest buying conditions in decades”, according to the University of Michigan’s latest consumer sentiment survey. If a positive demand shock was boosting incomes relative to prices, consumers would not be making this complaint. Given that they are making this complaint, there is the real risk of demand destruction. Meanwhile, employment remains far below its pre-pandemic trend. For example, in the US, by about 8 million jobs (Chart I-3). How can demand be on trend, but employment so far below trend? As an economic identity, the answer is that productivity has surged. Yet this should come as no surprise, because after recessions, productivity always surges. Chart I-2Demand Is On Trend... Demand Is On Trend... Demand Is On Trend... Chart I-3...But Employment Is Well Below Trend ...But Employment Is Well Below Trend ...But Employment Is Well Below Trend After Recessions, Productivity Always Surges As we explained in What The Olympics Teaches Us About Productivity Growth, productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways to do the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways to do the same thing, is a step function whose up-steps come after disruptive changes in the economy such as recessions (Chart I-4). Chart I-4After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges After Recessions, Productivity Always Surges To do things better, a recession is the necessary catalyst for the wholesale adoption of an existing technology. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression catalysed its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession finally killed the office typing pool. In the same way, the technology for remote meetings and online shopping has been around for years, but the pandemic has catalysed its wholesale adoption. Of course, it is sub-optimal to meet people remotely or shop online all the time. But it is also sub-optimal to do these things in-person all the time. The most productive way is some hybrid of remote and in-person, which will differ for each person. The pandemic has given us the opportunity to find this personally optimal hybrid, and thereby to boost our productivity. The current boost to productivity could be larger than those after previous recessions because the pandemic has reshaped the entire economy. The current boost to productivity could be larger than those after previous recessions because the pandemic has forced us all to challenge our best practices. This is different from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is reshaping the entire economy. Yet, if productivity is booming, why has inflation spiked? The answer is that we have experienced a massive and unprecedented (negative) supply shock. It’s A Supply Shock, Not A Demand Shock To repeat, there has been no positive shock in aggregate demand. Yet there has been a massive shock in the distribution of this demand. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. As spending on services slumped, consumers shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods (Chart I-5). Chart I-5A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks A Massive Displacement In The Distribution Of Demand Led To Supply Shocks The problem is that modern supply chains have few, if any, built-in redundancies. They are always working ‘just in time’ and cannot cope with any surge in demand. To make matters worse, the type of goods in high demand also shifted: for example, from electronic goods during full lockdown – to cars when lockdowns eased, and people required local mobility. These shifting spikes in demand stressed and indeed snapped fragile supply chains, resulting in skyrocketing prices for durables. To assess the contribution to overall inflation, we need to gauge the deviation from the pre-pandemic trend. Relative to where they would have been, prices are higher by 0.5 percent for services, 1 percent for non- durables, but by a staggering 10 percent for durables. It follows that most of the current burst of inflation is due to the supply shock for durables (Chart of the Week). But now, consumer complaints that “buying conditions are poor” imply that high prices risk demand destruction as people wait for better conditions (lower prices) to make non-essential purchases. In any case, as we learn to live with the pandemic, the shock in the distribution of demand is easing. Meaning that the abnormally high spending on durable goods has a long way to fall. Furthermore, supply bottlenecks always clear as output responds with a lag. This risks unleashing a flood of supply just as higher prices have destroyed demand. Add to this mix a slowdown, or worse a slump, in China’s real estate and construction sector as we highlighted last week in The Real Risk Is Real Estate (Part 2). And the irony is that, for many global sectors, there could be a demand shock after all but it would be a negative demand shock. Three Investment Recommendations As consumers’ current complaints of poor buying conditions testify, the higher prices that come from a supply shock eventually lead to demand destruction. Hence, it is extremely dangerous for central banks to respond with tighter policy, including the signalling of tighter policy that leads to higher bond yields. The higher bond yields will, with a lag, choke demand just as the supply bottlenecks ease and unleash a flood of supply. Resulting in a deflationary shock for the economy, stock market, and commodities (Chart I-6). Chart I-6When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump When Supply Shocks Ease, Prices Slump On this basis, we are making three investment recommendations: The upper limit to the 10-year T-bond is no higher than 1.8 percent, as we detailed in Stocks, Not The Economy, Will Set The Upper Limit To Bond Yields. Hence, this yield level would be a good cyclical entry point into both stocks and bonds. Continue to underweight consumer discretionary plays versus the market, given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market. As supply shocks always ultimately ease, those commodities whose prices have not yet corrected are at much greater risk than those commodities whose prices have corrected. Specifically, the price of industrial metals such as tin are at their most stretched versus iron ore in a decade (Chart I-7). Moreover, this fragility is confirmed by fractal analysis (Chart I-8 and Chart I-9). Chart I-7Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Tin Is Very Stretched Versus Iron Ore Chart I-8Tin Is Fragile Tin Is Fragile Tin Is Fragile Chart I-9Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Tin Versus Iron Ore Is Fragile Hence, as a new cyclical recommendation, go underweight tin versus iron ore. Netflix Versus Activision Blizzard, And AUD/NZD Are Susceptible To Reversal In pure entertainment plays, the strong outperformance of Netflix versus Activision Blizzard has been fuelled by the delta wave of the virus, which helped Netflix, combined with the Chinese crackdown on gaming companies, which weighed down the whole gaming sector including Activision. The gaming company was also hit by a discrimination lawsuit, which it has now settled. Fractal analysis suggests that this strong outperformance is now fragile. Accordingly, the recommended trade is to short Netflix versus Activision Blizzard, setting a profit target and symmetrical stop-loss at 10 percent (Chart I-10). Chart I-10Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Netflix Versus Activision Blizzard Is Susceptible To Reversal Meanwhile, in foreign exchange, the recent sell-off in AUD/NZD has reached fragility on the 130-day dimension which has reliably signalled previous reversal points (Chart I-11). Hence, the recommended trade is long AUD/NZD, setting a profit target and symmetrical stop-loss at 2 percent. Chart I-11AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound AUD/NZD Is Likely To Rebound   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear client, There will be no weekly bulletin next week. Instead, I will be hosting a webcast, with my colleague, Matt Gertken, titled “Currencies And Geopolitics: A Discussion.” I hope you will tune in so that we can have an interactive session. Also, we will be revamping the traditional backsections that FX has been publishing and will send a mockup in the coming weeks. Feedback on the new format will be greatly appreciated. Finally, I hosted a webcast this week with Japanese clients titled “A Guide To Currency Management For Japanese Corporates.” For those who are interested but were unable to attend, I encourage you to consult your sales representative for a replay. Kind regards, Chester Highlights The Fed will taper asset purchases this year, but it could be a non-event for the US dollar. The reason is that the Fed is lagging other G10 central banks in tapering asset purchases. Many will end QE even before the Fed begins tapering. The two big exceptions are the ECB and the BoJ. But while dovish monetary policy is well priced into both the interest rate curve and their currencies, upside surprises are not. Most global central banks will remain data dependent. So the key to gauging the move in currencies is to observe (and forecast) economic data. On that front, the current evidence is that US growth is robust, but is losing momentum to other developed markets. Volatility in currencies will be on the rise. We went long CHF/NZD on this basis last week and maintain long yen positions. But our bias is that any rally in the DXY will fizzle out at the 94-95 level. Feature This week was a busy one for central bankers. We kicked off with the Riksbank on Tuesday, the Bank of Japan and the Federal Reserve on Wednesday, and concluded with the Swiss National Bank, the Bank of England, and the Norges bank on Thursday. The highlight was the Fed, but the general message from most central banks is that less monetary accommodation will be forthcoming, as economic activity picks up. Most central bankers also admitted that inflation was proving a bit more sticky than initially anticipated. The key question therefore for currency strategists is whether the Federal Reserve will be more or less orthodox with monetary policy, compared to other developed market central banks, and what that means for the dollar. Our bias is that while the Fed was slightly more hawkish this week, it will continue to lag other G10 central banks in curtailing monetary accommodation. The Message From The FOMC Chart I-1The Market Has Priced Fed Hawkishness The Market Has Priced Fed Hawkishness The Market Has Priced Fed Hawkishness The key development from the Fed meeting this week was an upgrade to the dot plot. Half of the committee now expects at least one interest rate hike in 2022, with perhaps 7-8 hikes by the end of 2024. This is a more aggressive path of interest rate increases compared to the June FOMC meeting. The Fed also suggested tapering could begin at the next policy meeting and end towards the middle of next year, in time for rate increases. The immediate market response to the FOMC meeting did certainly suggest a hawkish undertone. The two-year US Treasury yield rose by 4 bps, which boosted the DXY index from a low of 93 to a high of 93.5 (intraday). Stocks rose and the 10-year Treasury yield edged mildly lower. The 30/2-year Treasury slope flattened by almost 10 bps. In our view, this was a rather muted response. For one, most of these moves are fading as we go to press. More importantly, going into the meeting, the market was already priced for a liftoff in 2022. This will suggest that the market was well positioned for Fed tapering at a minimum, and possibly an upgrade to the dots (Chart I-1). The Message From Other Central Banks While the Fed is still considering tapering asset purchases (and would very likely do so) by year-end, other central banks are well ahead in exiting emergency monetary settings. Just this week: The Norges bank hiked interest rates by 25 bps. We are particularly bullish on the krone, as highlighted in our Norwegian Method report; The Riskbank will end asset purchases this year. Its balance sheet is slated to be flat for 2022. It also closed all lending facilities launched during the pandemic. The offer for USD loans via the Fed’s swap facility will expire this month; The Bank of England kept monetary policy unchanged, but has already purchased £852bn of its £895bn target for government and corporate bonds. In fact, two of its members voted this week to reduce this target by £35bn, which would have effectively ended QE on a majority vote; The Swiss National Bank said in its introductory statement that it is fighting against an expensive franc, but modestly upgraded its inflation forecasts for 2022; The sole dovish central bank (aside from the SNB) was the Bank of Japan, but with elections on the horizon, and the possibility (or not) of a big fiscal package, their policy stance made sense.  Chart I-2Central Bank Holdings Of Government Bonds Central Bank Holdings Of Government Bonds Central Bank Holdings Of Government Bonds Elsewhere, the Bank of Canada has already cut its asset purchases in half, the Reserve Bank of New Zealand has ended QE, and the Reserve Bank of Australia has already been tapering asset purchases. In a nutshell, a Fed tapering at this point is well behind the actions of other G10 central banks. This is one key reason why the DXY index has failed to punch above the 94-95 level, and is relapsing as we go to press. From a bird’s eye view, many G10 central banks already have bloated balance sheets and a strong incentive to curtail asset purchases as growth recovers. Within the G10, the US central bank has the smallest holdings of outstanding bonds (Chart I-2). This not only means that, ceteris paribus, the incentive to taper asset purchases is bigger for other central banks, but the scope for the Federal Reserve to ease monetary policy is quite substantial should another shock occur. This might explain why there is unease among other central bankers, to exit emergency settings. Admittedly, this week, traditionally dovish central banks such as the Bank of Japan and the Swiss National Bank kept policy on hold and telegraphed a message that they will keep doing so for the foreseeable future. With a slightly more hawkish Federal Reserve, this should be a negative for these currencies. The same will apply to the ECB (Chart I-3). However, it is important to note that relatively dovish policy settings are well priced into both interest rate curves and their currencies, while upside surprises are not. The market does not expect any interest rate increases in the euro area or Japan before 2024, while it is priced for an aggressive pace of Fed rate hikes (Chart I-4). The starting point for any currency investor is an extremely dovish ECB and BoJ, relative to the Fed. Chart I-3A Pickup In US Yields Has Boosted The Dollar A Pickup In US Yields Has Boosted The Dollar A Pickup In US Yields Has Boosted The Dollar Chart I-4Markets Expect A More Aggressive Fed Markets Expect A More Aggressive Fed Markets Expect A More Aggressive Fed What Could Change? Global central banks are clearly focused on two goals – the outlook for growth and what that means for their maximum employment objective, and the long-run rate of inflation. These two objectives are interlinked. On the growth front, central bankers are justifiably admitting that the outlook remains clouded due to the Delta variant of COVID-19 and supply disruptions that are muddling the manufacturing outlook. However, it is important to remember that this is a global phenomenon. On a relative basis, there has been a growth rotation from the US to other economies that has historically supported the performance of DM currencies (Chart I-5). The primary reason is that many economies outside the US were in various forms of a lockdown over the last several months. As these economies reopen, so will economic activity. Chart I-5ARelative Growth And Currencies Relative Growth And Currencies Relative Growth And Currencies Chart I-5BRelative Growth And Currencies Relative Growth And Currencies Relative Growth And Currencies On the inflation front, the most acute problem has been tied to supply bottlenecks and this is not a US-centric problem. Inflation in the euro area, Sweden, the UK, Canada, or New Zealand are all above central bank targets (Table I-1). While all these central banks view the current overshoot as temporary, most have already pared back emergency monetary settings, as we highlighted above. Table I-1Inflation In The G10 A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar The key takeaway is that most central banks view inflation risks as symmetric, while the Fed has telegraphed it is willing to tolerate an inflation overshoot following downturns (Chart I-6). During the Fed’s last two meetings, it has been clear that there is a limit to how much of an overshoot they will tolerate. However, it still suggests that the Fed remains well behind the inflation curve, with one of the most negative 2-year rates in the G10 (Chart I-7). Chart I-6The Fed And Inflation Overshoots A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar Chart I-7Real Yields In The US Are Very Low A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar In a nutshell, if our bias turns out to be correct that growth does recover more earnestly outside the US, and other central banks remain more orthodox than the Fed, this will be a headwind for a stronger US dollar. A Final Note On Canada Canada re-elected a Liberal minority government on September 20. Prime Minister Justin Trudeau’s bet on a majority government, given an astute handling of the pandemic, and massive fiscal stimulus, failed. The implication is a continuation of the status quo in Canada. The good news is that the status quo is actually bullish for the loonie. As we highlighted in our recent report, minority governments tend to be positive for the loonie, while majority governments generally nudge the CAD lower post election (Chart I-8). The rationale is that fiscal policy is slated to stay easy, but not overly so, providing gentle room for the BoC to hike interest rates. Easy fiscal but tighter monetary policy is usually bullish for a currency. Chart I-8Historically, The CAD Likes A Minority Government Historically, The CAD Likes A Minority Government Historically, The CAD Likes A Minority Government Given our view on the US dollar, we expect the CAD/USD to punch above the recent 82-cent high, towards 85 and eventually 90 cents. While this view might take time to play out, both rising relative interest rates in Canada (our base case) and high oil prices will be the key catalysts. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar Strategtic View A Misconception About Fed Tapering And The Dollar A Misconception About Fed Tapering And The Dollar Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Closed Trades

Highlights We cannot predict how China will manage Evergrande precisely but we have a high conviction that it will do whatever it takes to prevent contagion across the property sector. However, China’s stimulus tools are losing their effectiveness over time. The country is due for a prolonged struggle with financial and economic instability regardless of whether Evergrande defaults. A messy default would obviously exacerbate the problem. China’s regulatory crackdowns target private companies and will continue to weigh on animal spirits in the private sector. The government will be forced to use fiscal policy to compensate. The US’s and China’s switch from engagement to confrontation poses a persistent headwind for investor sentiment toward China. The new consensus that investors should buy into China’s “strategic sectors” to avoid arbitrary regulatory crackdowns is vulnerable to its own logic and to sanctions by the US and its allies. Feature China poses a unique confluence of domestic and foreign political risks and global markets are now pricing them. Property giant Evergrande could default on $120 million in onshore and offshore interest payments as early as September 23, or next month, prompting investors to run for cover. Is this crisis fleeting or part of a larger systemic failure? It is a larger systemic failure. We expect a slow-motion, Japanese-style crisis over the coming decade, marked with periodic bailouts and stimulus packages. We recommend investors stay the course: steer clear of China and stay short the renminbi and Taiwanese dollar. Tactically, stick with large caps, defensive sectors, and developed markets within the global equity universe. Strategically, prefer emerging markets that benefit from forthcoming Chinese (and American) stimulus. 1. A “Minsky Moment” Cannot Be Ruled Out The chief fear is whether the approaching default of Evergrande marks China’s “Minsky Moment.” Hyman Minsky’s financial instability hypothesis held that long periods of stable revenues lead to risky financial deals and large accumulations of systemic risk that are underpriced. When revenues cannot cover interest payments, a crash ensues followed by deleveraging. Minsky’s hypothesis speaks to debt crises in an entire economy, yet nobody knows for sure whether China’s economy has reached such a breaking point. China’s national savings rate stands at 45.7% of GDP and nominal growth exceeds the long-term government bond yield. However, a sharp drop in asset prices, especially in the property sector, could change everything, as it could lead to balance sheet recession among corporates and a fall in national income. Evergrande is supposed to make an $84 million interest payment on offshore debt and a $36 million payment on onshore debt this week, and after 30 days it would default. It owes $37 billion in debt payments over the next 12 months but only has $13 billion cash on hand (as of June 30, 2021). Authorities can opt for a full bailout or a partial bailout, in which the company defaults on offshore bonds but not onshore. They could even let the company fail categorically, though that would produce exactly the kind of precipitous drop in property asset prices that would lead to wider financial contagion. State intervention to smooth the crisis is more likely – and the government can easily pressure other companies into acquiring Evergrande’s assets and business divisions. Chart 1Yes, This Could Be China's Minsky Moment Yes, This Could Be China's Minsky Moment Yes, This Could Be China's Minsky Moment Chart 1 shows that China’s corporate debt-to-GDP ratio stands head and shoulders above other countries that experienced financial crises in recent decades, courtesy of our Emerging Markets Strategy. While China can undoubtedly bear large debts due to its savings, the implication is that China has large enough financial imbalances to suffer a full-fledged financial crisis, even if the timing is hard to predict. Household credit is also elevated at 61.7% of GDP, and the household debt-to-disposable-income ratio is now higher than in the United States. About two-thirds of China’s corporate debt is held by state-owned or state-controlled entities, prompting some investors to dismiss the gravity of the risk. However, financial crises often involve the transfer of debt from the state to private sector or vice versa. 59% of bond defaults in H1 2021 have involved state companies. Total debt is the main concern. Don’t take our word for it: China’s Communist Party has warned for the past decade about the danger of “implicit guarantees” and “moral hazard” that encourage financial excesses in the corporate sector. The Xi Jinping administration has tried to induce a deleveraging process since it came to power in 2012-13. Xi’s “three red lines” for the property sector precipitated the current turmoil. Even if Evergrande’s troubles are managed, China’s systemic risks will continue to boil over as its potential growth rate slows and the government continues trying to wring out financial excesses. Chart 2Policy Uncertainty, Financial Stress Can Rise Higher Policy Uncertainty, Financial Stress Can Rise Higher Policy Uncertainty, Financial Stress Can Rise Higher More broadly China is experiencing an unprecedented overlap of economic and political crises: The population is aging and labor force is shrinking; The economic model since 2009 has been changing from export-manufacturing to domestic-oriented, investment-driven growth; Indebtedness is spreading from corporates to households and ultimately the government; The governance model is shifting from “single-party rule” to “single-person rule” or autocracy; The population is reaching middle class status and demanding better quality of life; The international trade environment is turning from hyper-globalization to hypo-globalization; The geopolitical backdrop is darkening with the US and its allies attempting to contain China’s ambitions of regional supremacy. Almost all of these changes bring more risks than opportunities to China over the long haul. The need for rapid policy shifts provides the ostensible reasoning for President Xi Jinping’s decision not to step down but to remain president for the foreseeable future. He will clinch this position at the twentieth national party congress in fall 2022. The implication is that policy uncertainty will continue climbing up to at least 2019 peaks while offshore equity markets will continue to trend lower, as they have done since the onset of the US trade war (Chart 2). Credit default swap rates have so far been subdued but they are showing signs of life. A sharp rise in policy uncertainty and property sector stress would pull them up. Domestic equities (A-shares) have rallied since 2019 but we would expect them to fall back given China’s historic confluence of structural and cyclical challenges, which will create further negative surprises (Chart 2, bottom panel). 2. Beijing Will Provide Bailouts And Stimulus Ad Nauseum Evergrande’s future may be in doubt but Beijing will throw all its power at stopping nationwide financial contagion. True, a policy miscalculation is possible. A tardy or failed intervention cannot be ruled out. However, investors should remember that a clear pattern of bailouts and stimulus has emerged over the course of the Xi Jinping administration whenever a “hard landing” or financial collapse loomed. The government tightens controls on bloated sectors until the financial fallout threatens to undermine general economic and social stability, at which point the government eases policy. It is often forced to stimulate the economy aggressively. Chart 3 shows these cycles in two ways: China’s control of credit through the state-controlled banks, and the frequency of news stories mentioning important terms associated with financial and economic distress: defaults, layoffs, and bankruptcies. These three terms used to be unheard of among China watchers. Under the Xi administration, a higher tolerance of creative destruction has served as the way to push forward reform. The current rise in distress is not extended, suggesting that more bad news is coming, but it also shows that the government has repeatedly been forced to provide stimulus even under the Xi administration. Chart 3Xi Jinping Has Bailed Out System Three Times Already Xi Jinping Has Bailed Out System Three Times Already Xi Jinping Has Bailed Out System Three Times Already Could this time be different? Not likely. The American experience and the pandemic will also force China’s government to ease policy: China learns from US mistakes. The US lurched from Lehman’s failure into a financial crisis, an impaired credit channel, a sluggish economic recovery, a spike in polarization, policy paralysis, a near-default on the national debt, a surge in right- and left-wing populism, the tumultuous Trump presidency, widespread social unrest, a contested leadership succession, and a mob storming the nation’s capitol (Chart 4). This is obviously the nightmare of any Chinese leader and a trajectory that the Xi administration will avoid at any cost. Chart 4Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Chinese households store their wealth in the property sector, so any attempt at policy restraint or austerity faces a massive constraint. Only a few countries are comparable to China with respect to the share of non-financial household wealth (property and land) within total household wealth. All of them are hosts of property sector bubbles, including the bubbles in Spain and Ireland back in 2007 (Chart 5). A property collapse would destroy the savings of the Chinese people over four decades of prosperity. Chart 5Property Is The Bedrock Of Chinese Households Five Points On China’s Crisis Five Points On China’s Crisis Social instability is already flaring up. Almost all China experts agree that “social stability” is the Communist Party’s bottom line. But note that the Evergrande saga has already led to protests, not only at the company’s headquarters in Shenzhen but also in other cities such as Shenyang, Guangzhou, Chongqing. Protests were filmed and shown on social media (posts have been censored). Protesters demanded repayment for wealth management products gone sour and properties they are owed that have not been built. This is only a taste of the cross-regional protests that would emerge if the broader property sector suffered. The lingering COVID-19 pandemic is still relevant. Investors should not underrate the potential threat that the pandemic poses to the regime. Severe epidemics have occurred about 11% of the time over the course of China’s history and they often have major ramifications. Disease has played a role in the downfall of six out of ten dynasties – and in four cases it played a major role. It would be suicidal for any regime to add self-inflicted economic collapse to a lingering pandemic (Table 1). Table 1Disease Threatens Chinese Dynasties – Not A Time To Self-Inflict A Recession Five Points On China’s Crisis Five Points On China’s Crisis Easing policy does not necessarily mean bringing out the “bazooka” and splurging on money and credit growth, though that is increasingly likely as the crisis intensifies. Notably the July Politburo statement specifically removed language that said China would “avoid sharp turns in policy.” In other words, sharp turns might be necessary. That can only mean sharp reflationary turns, as there is very little chance of doubling down on policy tightening. A counterargument holds that the Chinese government is now exclusively focused on power consolidation to the neglect of financial and economic stability. Perhaps the leadership is misinformed, overconfident, or thinks a financial collapse will better purge its enemies – along the lines of the various political purges under Chairman Mao Zedong. Wealthy tech magnates and property owners could conceivably challenge the return of autocracy. After all, the US political establishment almost “fell” to a rich property baron – why couldn’t China’s Communist Party? Political purges should certainly be expected ahead of next year’s party congress. But not to the point of killing the economy. The government would not be trying to balance policy tightening and loosening so carefully if it sought to induce chaos. It must be admitted, however, that the change to autocracy means that the odds of irrational or idiosyncratic policy have gone up substantially and permanently. Of course, the high likelihood that Beijing will provide bailouts and stimulus should not be read as a bullish investment thesis, even though it would create a pop in oversold assets. The Chinese system is saturated with money and credit, which have been losing their effectiveness in driving growth. Financial imbalances get worse, not better, with each wave of credit stimulus. Beijing is caught between a rock and a hard place. Hence stimulus comes only reluctantly and reactively. But it does come in the end because a financial crash would threaten the life of the regime and preclude all other policy priorities, domestic and foreign. 3. Yes, China’s Regulatory Crackdown Targets The Private Sector Global growth and other emerging economies will get most of the benefit once China stimulates, since China’s own firms will still face a negative domestic political backdrop. Bullish investors argue that the government’s regulatory tightening is misunderstood and overblown. The claim is that China is not targeting the private sector generally but only isolated sectors causing social problems. Costs need to be reduced in property, education, and health to improve quality of life. China shares the US’s and EU’s desire to rein in tech giants that monopolize their markets, abuse consumer data and privacy, and benefit from distorted tax systems. Most of these arguments are misleading. China does not have a strong record on data privacy, equality, social safety nets, rule of law, or “sustainable” growth (as opposed to “unsustainable,” high-debt, high-polluting growth). China actively encourages state champions that monopolize key sectors. Many developed markets have better records in these areas, notably in Europe, yet China is eschewing these regulatory models in preference for an approach that is arbitrary and absolutist, i.e. negative for governance. As for the private sector, animal spirits have been in a long decline throughout the past decade. This is true whether judging by money velocity – i.e. the pace of economic activity relative to the increase in money supply – or by households’ and businesses’ marginal propensity to save (Chart 6). The 2015-16 period shows that even periodic bouts of government stimulus have not reversed the general trend. Regulatory whack-a-mole and financial turmoil will not improve the situation. Chart 6Private Sector Animal Spirits Depressed Throughout Xi Era Private Sector Animal Spirits Depressed Throughout Xi Era Private Sector Animal Spirits Depressed Throughout Xi Era Chart 7Even Official Data Shows Consumer Confidence Flagging Even Official Data Shows Consumer Confidence Flagging Even Official Data Shows Consumer Confidence Flagging Surveys of sentiment confirm that the latest developments will have a negative effect (Chart 7). Cumulatively, the changes in China’s domestic and international policy context are being interpreted as negative for business, entrepreneurship, and economic freedom – notwithstanding the government’s claims to expand opportunity in its “common prosperity” plan. 4. The Withdrawal Of US Friendship Is A Headwind For China Chart 8Other Asians Sought US Friendship, Not Conflict, When Export Models Expired Other Asians Sought US Friendship, Not Conflict, When Export Models Expired Other Asians Sought US Friendship, Not Conflict, When Export Models Expired All of the successful Asian economies – including China for most of the past forty years of prosperity – have tried to stay on the good side of the United States. By contrast, China and the US today are shifting from engagement to confrontation and breaking up their economic ties (Chart 8). This is a problem for China because the US and to some extent its allies will seek to undermine China’s economy and its autocratic model as part of this great power competition. The rise in geopolitical risk is underscored by the Australia-UK-US (AUKUS) agreement, by which the US will provide Australia with nuclear submarines over the next decade. This was a clear demonstration of the US’s “pivot to Asia” and the fact that the US and China are preparing for war – if only to deter it. China’s return to autocracy and clash with the US and Asian neighbors is also leading to a deterioration of its global image, particularly over issues of transparency and information sharing. The dispute over the origins of COVID-19 is a major source of division with the US and other countries. Transparency is important for investors. The World Bank has discontinued its “Ease of Doing Business” rankings after a scandal was revealed in which China’s ranking was artificially bumped up. The last-published trend is still downward (Chart 9). Most recently China has stepped up censorship of its financial news media amid the current market turmoil, which makes it harder for investors to assess the full extent of property and financial risks.1 The US political factions agree on China-bashing if nothing else. The Biden administration has little political impetus to eschew tariffs and export controls. One important penalty will come from the Securities and Exchange Commission, which is likely to ban Chinese firms from US stock exchanges unless they conform to common accounting standards. Hence the dramatic fall in the share prices of Chinese companies listed via American Depository Receipts (ADRs), in both absolute and relative terms (Chart 10, top panel). This threat prompted China’s recent crackdown on its own firms that were attempting to hold initial public offerings on US exchanges. Chart 9US Conflict Exposes China’s Global Influence Campaign Five Points On China’s Crisis Five Points On China’s Crisis The Quadrilateral Forum – the US, Japan, Australia, and India – has agreed to link the semiconductor supply chain to human rights standards, foreclosing China’s participation in that supply chain. US semiconductor firms are among the most exposed to China but they have not suffered over the course of the US-China tech war, suggesting that US vulnerabilities are limited (Chart 10, bottom panel). Chart 10US Regulators Will Kick Chinese Firms While They Are Down US Regulators Will Kick Chinese Firms While They Are Down US Regulators Will Kick Chinese Firms While They Are Down The point is not to exaggerate the strength of the US and its allies but rather the costs to China of actively opposing them. The US has a difficult enough time cobbling together a coalition of states to impose sanctions on Iran over its nuclear program, not to mention forming any coalition that would totally exclude and isolate China. China is far more important to US allies than Iran – it is irreplaceable in the global economy (Chart 11). The EU and China’s Asian neighbors will typically restrain the US’s more aggressive impulses so as not to upset the global recovery or end up on the front lines of a war.2 Chart 11No Substitute For China In Global Economy Five Points On China’s Crisis Five Points On China’s Crisis This diplomatic constraint on the US is probably positive for global growth but not for China per se. American allies are still able to increase the costs on China for pursuing its own state-backed development path and geopolitical sphere of influence. Japan, Australia, and others are likely to veto China’s application to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), while the UK and eventually the US are likely to join it. Investors should view US-China ties as a headwind at least until the two powers manage to negotiate a diplomatic thaw, i.e. substantial de-escalation of tensions. A thaw is unlikely in the lead-up to Xi Jinping’s consolidation of power and the US midterm elections in fall 2022. Presidents Biden and Xi are still working on a bilateral summit, not to mention a more substantial improvement in ties. We doubt a diplomatic thaw would be durable anyway but the important point is that until it happens China will face periodic bouts of negative sentiment from the emerging cold war. Other Asian economies thrived under US auspices – China is sailing in uncharted waters. 5. Global Investors Cannot Separate Civilian From State And Military Investments The word on Wall Street is that investors should align their strategies with those of China’s leaders so as not to run afoul of arbitrary and draconian regulators. For example, instead of “soft tech” or consumer-oriented companies – like those that give people rides, deliver food, or make creative video games – investors should invest in “hard tech” or strategic companies like those that make computer chips, renewable energy, biotechnologies, pharmaceuticals, and capital equipment. There is no question that the trend in China – and elsewhere – is for governments to become more active in picking winners and losers. Industrial policy is back. Investors have no choice but to include policy analysis in their toolbox. However, for global investors, an investment strategy of buying whatever the government says is far from convincing. The most basic investment strategy in keeping with the Xi administration’s goals would be to invest in state-owned enterprises in domestic equity markets. So SOEs should have outperformed the market, right? Wrong. They were in a downtrend prior to the 2015 bubble, the burst of which caused a further downtrend (Chart 12, top panel). Similarly, the preference for “hard tech” over “soft tech” is promising in theory but complicated in practice: hard tech is flat-to-down over the decade and down since COVID-19 (Chart 12, middle panel). It has underperformed its global peers (Chart 12, bottom panel). China’s policy disposition should be beneficial for industrials, health care, and renewable energy. First, China is doubling down on its manufacturing economy. Second, the population is aging and health care is a critical part of the common prosperity plan. Third, green energy is a way of diversifying from dependency on imported oil and natural gas. However, the profile of these sectors relative to their global counterparts is only unambiguously attractive in the case of industrials, which began to outperform even during the trade war (Chart 13). Chart 12State Approved' Trades Still Bring Risks State Approved' Trades Still Bring Risks State Approved' Trades Still Bring Risks Chart 13Beware 'State Approved' Trades Beware 'State Approved' Trades Beware 'State Approved' Trades In Table 2 we outline the valuations and political risks of onshore equity sectors. Valuations are not cheap. Domestic and foreign risks are not fully priced. Table 2China Onshore Equities, Valuations, And (Geo)Political Risks Five Points On China’s Crisis Five Points On China’s Crisis There is a bigger problem for global investors, especially Americans: investing in China’s strategic sectors directly implicates investors in the Communist Party’s domestic human rights practices, state-owned enterprises, and national security goals. “Civil-military fusion” is a well-established doctrine that calls for the People’s Liberation Army to have access to the cutting-edge technology developed by civilians and vice versa. These investments will eventually be subject to punitive measures since the US policy establishment believes it can no longer afford to let US wealth buttress China’s military and technological rise. Investment Takeaways China may or may not work out a partial bailout for Evergrande but it will definitely provide state assistance and fiscal stimulus to try to prevent contagion across the property sector and financial system. Bad news in the coming weeks and months will be replaced by good news in this sense. However, the fact that China will eventually be forced to undertake traditional stimulus yet again will increase its systemic financial risks, in a well-established pattern. The best equity opportunities will lie outside of China, where companies will benefit from global recovery yet avoid suffering from China’s unique confluence of domestic and foreign political risks. We prefer developed markets and select emerging markets in Latin America and Asia-ex-China. Chinese households and businesses are downbeat. This behavior cannot be separated from the historic changes in the economy, domestic politics, and foreign policy. It is hard to see an improvement until the government boosts growth and the 2022 political reshuffle is over. American opposition is a bigger problem for China than global investors realize. Not only are the two economies divorcing but other democracies will distance themselves from China as well – not because of US demands but because their own manufacturing, national security, and ideological space is threatened by China’s reversion to autocracy and assertive foreign policy. Investing in China’s “hard tech” and strategic sectors with government approval is not a simple solution. This approach will directly funnel capital into China’s state-owned enterprises, domestic security forces, and military. As such the US and West will eventually impose controls. Investments may not be liquid since China would suffer if capital ever fled these kinds of projects. Both American and Chinese stimulus is looming this winter but the short run will see more volatility. We are closing our long JPY-KRW tactical trade for a gain of 4.4%   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We have often noted in these pages over the past decade that multilateral organizations overrated improvements in China’s governance based on policy pronouncements rather than structural changes. 2 Still, tensions among the allies should not be overrated since they share a fundamental concern over China’s increasing challenge to the current global order. The EU is pursuing trade talks with Taiwan, and there are ways that the US can compensate France over the nullification of its submarine sales to Australia (most of which are detrimental to China’s security).

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

Highlights An Iran crisis is imminent. We still think a US-Iran détente is possible but our conviction is lower until Biden makes a successful show of force. Oil prices will be volatile. Fiscal drag is a risk to the cyclical global macro view. But developed markets are more fiscally proactive than they were after the global financial crisis. Elections will reinforce that, starting in Germany, Canada, and Japan. The Chinese and Russian spheres are still brimming with political and geopolitical risk. But China will ease monetary and fiscal policy on the margin over the coming 12 months. Afghanistan will not upset our outlook on the German and French elections, which is positive for the euro and European stocks. Feature Chart 1Bull Market In Iran Tensions Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Iran is now the most pressing geopolitical risk in the short term (Chart 1). The Biden administration has been chastened by the messy withdrawal from Afghanistan and will be exceedingly reactive if it is provoked by foreign powers. Nuclear weapons improve regime survivability. Survival is what the Islamic Republic wants. Iran is surrounded by enemies in its region and under constant pressure from the United States. Hence Iran will never ultimately give up its nuclear program, as we have maintained. Chart 2Biden Unlikely To Lift Iran Sanctions Unilaterally Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) However, Supreme Leader Ali Khamenei could still agree to a deal in which the US reduces economic sanctions while Iran allows some restrictions on uranium enrichment for a limited period of time (the 2015 nuclear deal’s key provisions expire from 2023 through 2030). This would be a stopgap measure to delay the march into war. The problem is that rejoining the 2015 deal requires the US to ease sanctions first, since the US walked away from the deal in 2018. Iran would need domestic political cover to rejoin it. Biden has the executive authority to ease sanctions unilaterally but after Afghanistan he lacks the political capital to do so (Chart 2). So Biden cannot ease sanctions until Iran pares back its nuclear activities. But Iran has no reason to pare back if the US does not ease sanctions. Iran is now enriching some uranium to a purity of 60%. Israeli Defense Minister Benny Gantz says it will reach “nuclear breakout” capability – enough fissile material to build a bomb – within 10 weeks, i.e. mid-October. Anonymous officials from the Biden administration told the Associated Press it will be “months or less,” which could mean September, October, or November (Table 1). Table 1Iran Nearing "Breakout" Nuclear Capability Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Meanwhile the new Iranian government of President Ebrahim Raisi, a hardliner who is tipped to take over as Supreme Leader once Ali Khamenei steps down, is implying that it will not rejoin negotiations until November. All of these timelines are blurry but the implication is that Iran will not resume talks until it has achieved nuclear breakout. Israel will continue its campaign of sabotage against the regime. It may be pressed to the point of launching air strikes, as it did against nuclear facilities in Iraq in 1981 and Syria in 2007 under what is known as the “Begin Doctrine.” Chart 3Israel Cannot Risk Losing US Security Guarantee Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) The constraint on Israel is that it cannot afford to lose America’s public support and defense alliance since it would find itself isolated and vulnerable in its region (Chart 3). But if Israeli intelligence concludes that the Iranians truly stand on the verge of achieving a deliverable nuclear weapon, the country will likely be driven to launch air strikes. Once the Iranians test and display a viable nuclear deterrent it will be too late. Four US presidents, including Biden, have declared that Iran will not be allowed to get nuclear weapons. Biden and the Democrats favor diplomacy, as Biden made clear in his bilateral summit with Israeli Prime Minister Naftali Bennett last week. But Biden also admitted that if diplomacy fails there are “other options.” The Israelis currently have a weak government but it is unified against a nuclear-armed Iran. At very least Bennett will underscore red lines to indicate that Israel’s vigilance has not declined despite hawkish Benjamin Netanyahu’s fall from power. Still, Iran may decide it has an historic opportunity to make a dash for the bomb if it thinks that the US will fail to support an Israeli attack. The US has lost leverage in negotiations since 2015. It no longer has troops stationed on Iran’s east and west flanks. It no longer has the same degree of Chinese and Russian cooperation. It is even more internally divided. Iran has no guarantee that the US will not undergo another paroxysm of nationalism in 2024 and try to attack it. The faction that opposed the deal all along is now in power and may believe it has the best chance in its lifetime to achieve nuclear breakout. The only reason a short-term deal is possible is because Khamenei may believe the Israelis will attack with full American support. He agreed to the 2015 deal. He also fears that the combination of economic sanctions and simmering social unrest will create a rift when he dies or passes the leadership to his successor. Iran has survived the Trump administration’s “maximum pressure” sanctions but it is still vulnerable (Chart 4). Chart 4Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Moreover Biden is offering Khamenei a deal that does not require abandoning the nuclear program and does not prevent Iran from enhancing its missile capabilities. By taking the deal he might prevent his enemies from unifying, forestall immediate war, and pave the way for a smooth succession, while still pursuing the ultimate goal of nuclear weaponization. Bringing it all together, the world today stands at a critical juncture with regard to Iran and the unfinished business of the US wars in the Middle East. Unless the US and Israel stage a unified and convincing show of force, whether preemptively or in response to Iranian provocations, the Iranians will be justified in concluding that they have a once-in-a-generation opportunity to pursue the bomb. They could sneak past the global powers and obtain a nuclear deterrent and regime security, like North Korea did. This could easily precipitate a war. Biden will probably continue to be reactive rather than proactive. If the Iranians are silent then it will be clear that Khamenei still sees the value in a short-term deal. But if they continue their march toward nuclear breakout, as is the case as we go to press, then Biden will have to make a massive show of force. The goal would be to underscore the US’s red lines and drive Iran back to negotiating table. If Biden blinks, he will incentivize Iran to make a dash for the bomb. Either way a crisis is imminent. Israel will continue to use sabotage and underscore red lines while the Iranians will continue to escalate their attacks on Israel via militant proxies and attacks on tankers (Map 1). Map 1Secret War Escalates In Middle East Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Bottom Line: After a crisis, either diplomacy will be restored, or the Middle East will be on a new war path. The war path points to a drastically different geopolitical backdrop for the global economy. If the US and Iran strike a short-term deal, Iranian oil will flow and the US will shift its strategic focus to pressuring China, which is negative for global growth and positive for the dollar. If the US and Iran start down the war path, oil supply disruptions will rise and the dollar will fall. Implications For Oil Prices And OPEC 2.0 The probability of a near-term conflict is clear from our decision tree, which remains the same as in June 2019 (Diagram 1). Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Shows of force and an escalation in the secret war will cause temporary but possibly sharp spikes in oil prices in the short term. OPEC 2.0 remains intact so far this year, as expected. The likelihood that the global economic recovery will continue should encourage the Saudis, Russians, Emiratis and others to maintain production discipline to drain inventories and keep Brent crude prices above $60 per barrel. OPEC 2.0 is a weak link in oil prices, however, because Russians are less oil-dependent than the Gulf Arab states and do not need as high of oil prices for their government budget to break even (Chart 5). Periodically this dynamic leads the cartel to break down. None of the petro-states want to push oil prices up so high that they hasten the global green energy transition. Chart 5OPEC 2.0 Keeps Price Within Fiscal Breakeven Oil Price Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 6Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs As long as OPEC 2.0 remains disciplined, average Brent crude oil prices will gradually rise to $80 barrels per day by the end of 2024, according to our Commodity & Energy Strategy (Chart 6). Imminent firefights will cause prices to spike at least temporarily when large amounts of capacity are taken offline. Global spare capacity is probably sufficient to handle one-off disruptions but an open-ended military conflict in the Persian Gulf or Strait of Hormuz would be a different story. After the next crisis, everything depends on whether the US and Israel establish a credible threat and thus restore diplomacy. Any US-Iran strategic détente would unleash Iranian production and could well motivate the Gulf Arabs to pump more oil and deny Iran market share. Bottom Line: Given that any US-Iran deal would also be short-term in nature, and may not even stabilize the region, some of the downside risks are fading at the moment. The US and China are also sucking in more commodities as they gear up for great power struggle. The geopolitical outlook is positive for oil prices in these respects. But OPEC 2.0 is the weak link in this expectation so we expect volatility. Global Fiscal Taps Will Stay Open Markets have wavered in recent months over softness in the global economic recovery, COVID-19 variants, and China’s policy tightening. The world faces a substantial fiscal drag in the coming years as government budgets correct from the giant deficits witnessed during the crisis. Nevertheless policymakers are still able to deliver some positive fiscal surprises on the margin. Developed markets have turned fiscally proactive over the past decade. They rejected austerity because it was seen as fueling populist political outcomes that threatened the established parties. Note that this change began with conservative governments (e.g. Japan, UK, US, Germany), implying that left-leaning governments will open the fiscal taps further whenever they come to power (e.g. Canada, the US, Italy, and likely Germany next). Chart 7Global Fiscal Taps Will Stay Open Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 7 updates the pandemic-era fiscal stimulus of major economies, with light-shaded bars highlighting new fiscal measures that are in development but have not yet been included in the IMF’s data set. The US remains at the top followed by Italy, which also saw populist electoral outcomes over the past decade. Chart 8US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 The Biden administration is on the verge of passing a $550 billion bipartisan infrastructure bill. We maintain 80% subjective odds of passage – despite the messy pullout from Afghanistan. Assuming it passes, Democrats will proceed to their $3.5 trillion social welfare bill. This bill will inevitably be watered down – we expect a net deficit impact of around $1-$1.5 trillion for both bills – but it can pass via the partisan “budget reconciliation” process. We give 50% subjective odds today but will upgrade to 65% after infrastructure passes. The need to suspend the debt ceiling will raise volatility this fall but ultimately neither party has an interest in a national debt default. The US is expanding social spending even as geopolitical challenges prevent it from cutting defense spending, which might otherwise be expected after Afghanistan and Iraq. The US budget balance will contract after the crisis but then it will remain elevated, having taken a permanent step up as a result of populism. The impact should be a flat or falling dollar on a cyclical basis, even though we think geopolitical conflict will sustain the dollar as the leading reserve currency over the long run (Chart 8). So the dollar view remains neutral for now. Bottom Line: The US is facing a 5.9% contraction in the budget deficit in 2022 but the blow will be cushioned somewhat by two large spending bills, which will put budget deficits on a rising trajectory over the course of the decade. Big government is back. Developed Market Fiscal Moves (Outside The US) Chart 9German Opinion Favors New Left-Wing Coalition Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Fiscal drag is also a risk for other developed markets – but here too a substantial shift away from prudence has taken place, which is likely to be signaled to investors by the outperformance of left-wing parties in Germany’s upcoming election. Germany is only scheduled to add EUR 2.4 billion to the 25.6 billion it will receive under the EU’s pandemic recovery fund, but Berlin is likely to bring positive fiscal surprises due to the federal election on September 26. Germany will likely see a left-wing coalition replace Chancellor Angela Merkel and her long-ruling Christian Democrats (Chart 9). The platforms of the different parties can be viewed in Table 2. Our GeoRisk Indicator for Germany confirms that political risk is elevated but in this case the risk brings upside to risk assets (Appendix). Table 2German Party Platforms Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) While we expected the Greens to perform better than they are in current polling, the point is the high probability of a shift to a new left-wing government. The Social Democrats are reviving under the leadership of Olaf Scholz (Chart 10). Tellingly, Scholz led the charge for Germany to loosen its fiscal belt back in 2019, prior to the global pandemic. Chart 10Germany: Online Markets Betting On Scholz Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 11Canada: Trudeau Takes A Calculated Risk Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) In June, the cabinet approved a draft 2022 budget plan supported by Scholz that would contain new borrowing worth EUR 99.7 bn ($119 billion). This amount is not included in the chart above but it should be seen as the minimum to be passed under the new government. If a left-wing coalition is formed, as we expect, the amount will be larger, given that both the Social Democrats and the Greens have been restrained by Merkel’s party. Canada turned fiscally proactive in 2015, when the institutional ruling party, the Liberals, outflanked the more progressive New Democrats by calling for budget deficits instead of a balanced budget. The Liberals saw a drop in support in 2019 but are now calling a snap election. Prime Minister Trudeau is not as popular in general opinion as he is in the news media but his party still leads the polls (Chart 11). The Conservatives are geographically isolated and, more importantly, are out of step with the median voter on the key issues (Table 3). Table 3Canada: Liberal Agenda Lines Up With Top Voter Priorities Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Nevertheless it is a risky time to call an election – our GeoRisk Indicator for Canada is soaring (Appendix). Granting that the Liberals are very unlikely to fall from power, whatever their strength in parliament, the key point is that parliament already approved of CAD 100 billion in new spending over the coming three years. Any upside surprise would give Trudeau the ability to push for still more deficit spending, likely focused on climate change. Chart 12Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japanese politics are heating up ahead of the Liberal Democrats’ leadership election on September 29 and the general election, due by November 28. Prime Minister Yoshihide Suga’s sole purpose in life was to stand in for Shinzo Abe in overseeing the Tokyo Olympics. Now they are done and Suga will likely be axed – if he somehow survives the election, he will not last long after, as his approval rating is in freefall. The Liberal Democrats are still the only game in town. They will try to minimize the downside risks they face in the general election by passing a new stimulus package (Chart 12). Rumor has it that the new package will nominally be worth JPY 10-15 trillion, though we expect the party to go bigger, and LDP heavyweight Toshihiro Nikai has proposed a 30 trillion headline number. It is extremely unlikely that the election will cause a hung parliament or any political shift that jeopardizes passage of the bill. Abenomics remains the policy setting – and consumption tax hikes are no longer on the horizon to impede the second arrow of Abenomics: fiscal policy. Not all countries are projecting new spending. A stronger-than-expected showing by the Christian Democrats would result in gridlock in Germany. Meanwhile the UK may signal belt-tightening in October. Bottom Line: Germany, Canada, and Japan are likely to take some of the edge off of expected fiscal drag next year. Emerging Market Fiscal Moves (And China Regulatory Update) Among the emerging markets, Russia and China are notable in Chart 7 above for having such a small fiscal stimulus during this crisis. Russia has announced some fiscal measures ahead of the September 19 Duma election but they are small: $5.2 billion in social spending, $10 billion in strategic goals over three years, and a possible $6.8 billion increase in payments to pensioners. Fiscal austerity in Russia is one reason we expect domestic political risk to remain elevated and hence for President Putin to stoke conflicts in his near abroad (see our Russian risk indicator in the Appendix). There are plenty of signs that Belarussian tensions with the Baltic states and Poland can escalate in the near term, as can fighting in Ukraine in the wake of Biden’s new defense agreement and second package of military aid. China’s actual stimulus was much larger than shown in Chart 7 above because it mostly consisted of a surge in state-controlled bank lending. China is likely to ease monetary and fiscal policy on the margin over the coming 12 months to secure the recovery in time for the national party congress in 2022. But China’s regulatory crackdown will continue during that time and our GeoRisk Indicator clearly shows the uptick in risk this year (Appendix). Chart 13China Expands Unionization? China Expands Unionization? China Expands Unionization? The regulatory crackdown is part of a cyclical consolidation of Xi Jinping’s power as well as a broader, secular trend of reasserting Communist Party and centralization in China. The latest developments underscore our view that investors should not play any technical rebound in Chinese equities. The increase in censorship of financial media is especially troubling. Just as the government struggles to deal with systemic financial problems (e.g. the failing property giant Evergrande, a possible “Lehman moment”), the lack of transparency and information asymmetry will get worse. The media is focusing on the government’s interventions into public morality, setting a “correct beauty standard” for entertainers and limiting kids to three hours of video games per week. But for investors what matters is that the regulatory crackdown is proceeding to the medical sector. High health costs (like high housing and education costs) are another target of the Xi administration in trying to increase popular support and legitimacy. Central government-mandated unionization in tech companies will hurt the tech sector without promoting social stability. Chinese unions do not operate like those in the West and are unlikely ever to do so. If they did, it would compound the preexisting structural problem of rising wages (Chart 13). Wages are forcing an economic transition onto Beijing, which raises systemic risks permanently across all sectors. Bottom Line: Political and geopolitical risk are still elevated in China and Russia. China will ease monetary and fiscal policy gradually over the coming year but the regulatory crackdown will persist at least until the 2022 political reshuffle. Afghanistan: The Refugee Fallout September 2021 will officially mark the beginning of Taliban’s second bout of power in Afghanistan. Will Afghanistan be the only country to spawn an outflux of refugees? Will the Taliban wresting power in Afghanistan trigger another refugee crisis for Europe? How is the rise of the Taliban likely to affect geopolitics in South Asia? Will Afghanistan Be The Last Major Country To Spawn Refugees? Absolutely not. We expect regime failures to affect the global economy over the next few years. The global growth engine functions asymmetrically and is powered only by a fistful of countries. As economic growth in poor countries fails to keep pace with that of top performers, institutional turmoil is bound to follow. This trend will only add to the growing problem of refugees that the world has seen in the post-WWII era. History suggests that the number of refugees in the world at any point in time is a function of economic prosperity (or the lack thereof) in poorer continents (Chart 14). For instance, the periods spanning 1980-90 and 2015-20 saw the world’s poorer continents lose their share in global GDP. Unsurprisingly these phases also saw a marked increase in the number of refugees. With the world’s poorer continents expected to lose share in global GDP again going forward, the number of refugees in the world will only rise. Chart 14Refugee Flows Rise When Growth Weak In Poor Continents Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Citizens of Syria, Venezuela, Afghanistan, South Sudan, and Myanmar today account for two-thirds of all refugees globally. To start with, these five countries’ share in global GDP was low at 0.8% in the 1980s. Now their share in global GDP is set to fall to 0.2% over the next five years (Chart 15). Chart 15Refugee Exporters Hit All-Time Low In Global GDP Share Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Per capita incomes in top refugee source countries tend to be very low. Whilst regime fractures appear to be the proximate cause of refugee outflux, an economic collapse is probably the root cause of the civil strife and waves of refugee movement seen out of the top refugee source countries. Another factor that could have a bearing is the rise of multipolarity. Shifting power structures in the global economy affect the stability of regimes with weak institutions. Instability in Afghanistan has been a direct result of the rise and the fall of the British and Russian empires. American imperial overreach is just the latest episode. If another Middle Eastern war erupts, the implications are obvious. But so too are the implications of US-China proxy wars in Southeast Asia or Russia-West proxy wars in eastern Europe. Bottom Line: With poorer continents’ economic prospects likely to remain weak and with multipolarity here to stay, the world’s refugee problem is here to stay too. Is A Repeat Of 2015 Refugee Crisis Likely In 2021? No. 2021 will not be a replica of 2015. This is owing to two key reasons. First, Afghanistan has long witnessed a steady outflow of refugees – especially at the end of the twentieth century but also throughout the US’s 20-year war there. The magnitude of the refugee problem in 2021 will be significantly smaller than that in 2015. Secondly, voters are now differentiating between immigrants and refugees with the latter entity gaining greater acceptance (Chart 16). Chart 16DM Attitudes Permissive Toward Refugees Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 17Refugees Will Not Change Game In German/French Elections Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Concerns about refugees will gain some political traction but it will reinforce rather than upset the current trajectory in the most important upcoming elections, in Germany in September and France next April. True, these countries feature in the list of top countries to which Afghan refugees flee and will see some political backlash (Chart 17). But the outcome may be counterintuitive. In the German election, any boost to the far-right will underscore the likely underperformance of the ruling Christian Democrats. So the German elections will produce a left-wing surprise – and yet, even if the Greens won the chancellorship (the true surprise scenario, looking much less likely now), investors will cheer the pro-Europe and pro-fiscal result. The French election is overcrowded with right-wing candidates, both center-right and far-right, giving President Macron the ability to pivot to the left to reinforce his incumbent advantage next spring. Again, the euro and the equity market will rise on the status quo despite the political risk shown in our indicator (Appendix). Of course, immigration and refugees will cause shocks to European politics in future, especially as more regime failures in the third world take place to add to Afghanistan and Ethiopia. But in the short run they are likely to reinforce the fact that European politics are an oasis of stability given what is happening in the US, China, Brazil, and even Russia and India. Bottom Line: 2021 will not see a repeat of the 2015 refugee crisis. Ironically Afghan refugees could reinforce European integration in both German and French elections. The magnitude of the Afghan crisis is smaller than in the past and most Afghan refugees are likely to migrate to Pakistan and Iran (Chart 17). But more regime failures will ensure that the flow of people becomes a political risk again sometime in the future. What Does The Rise Of Taliban Mean For India? The Taliban first held power in Afghanistan from 1996-2001. This was one of the most fraught geopolitical periods in South Asia since the 1970s. Now optimists argue that Taliban 2.0 is different. Taliban leaders are engaging in discussions with an ex-president who was backed by America and making positive overtures towards India. So, will this time be different? It is worth noting that Taliban 2.0 will have to function within two major constraints. First, Afghanistan is deeply divided and diverse. Afghanistan’s national anthem refers to fourteen ethnic groups. Running a stable government is inherently challenging in this mountainous country. With Taliban being dominated by one ethnic group and with limited financial resources at hand, the Taliban will continue to use brute force to keep competing political groups at bay. Chart 18Taliban In Line With Afghanis On Sharia Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) At the same time, to maintain legitimacy and power, the Taliban will have to support aligned political groups operating in Afghanistan and neighboring Pakistan. Second, an overwhelming majority of Afghani citizens want Sharia law, i.e. a legal code based on Islamic scripture as the official law of the land (Chart 18). Hence if the Taliban enforces a Sharia-based legal system in Afghanistan then it will fall in line with what the broader population demands. It is against this backdrop that Taliban 2.0 is bound to have several similarities with the version that ruled from 1996-2001. Additionally, US withdrawal from Afghanistan will revive a range of latent terrorist movements in the region. This poses risks for outside countries, not least India, which has a long history of being targeted by Afghani terrorist groups. The US will remain engaged in counter-terrorism operations. To complicate matters, India’s North has an even more unfavorable view of Pakistan than the rest of India. With the northern voter’s importance rising, India’s administration may be forced to respond more aggressively to a terrorist event than would have been the case about a decade ago. It is also possible that terrorism will strike at China over time given its treatment of Uighur Muslims in Xinjiang. China’s economic footprint in Afghanistan could precipitate such a shift. Bottom Line: US withdrawal from Afghanistan is bound to add to geopolitical risks as latent terrorist forces will be activated. India has a long history of being targeted by Afghani terrorist movements. Incidentally, it will take time for transnational terrorism based in Afghanistan to mount successful attacks at the West once again, given that western intelligence services are more aware of the problem than they were in 2000. But non-state actors may regain the element of surprise over time, given that the western powers are increasingly focused on state-to-state struggle in a new era of great power competition.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@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

Highlights The US dollar’s reserve status will remain intact for the foreseeable future. While this privilege is fraying at the edges, there are no viable alternatives just yet. There is an overarching incentive for any country to hold onto its currency’s power. For the US, it is still well within their ability to keep this “exorbitant privilege.” That said, there will be rolling doubts about the ability of the US to maintain its large currency sphere. This will create tidal waves in the currency’s path, providing plenty of trading opportunities for investors. China is on track to surpass the US in economic size, but it is far from dethroning the US in the military realm. However, it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Watch the RMB over the next few decades. From a macro and cyclical perspective, the dollar is likely to decline as global growth picks up and the Fed lags market expectations in raising rates. From a geopolitical perspective, however, the backdrop is neutral-to-bullish for the dollar over the next three to five years. Feature Having the world’s reserve currency comes with a few advantages, which any governments would be loath to give up. The most important advantage is the ability to settle one’s balance of payments in one’s own currency. This not only facilitates trade for the reserve nation, it also reinforces the turnover of the reserve currency internationally. The value of this privilege is as much symbolic as economic. This “first mover advantage” or adoption of one’s currency internationally automatically ordains the resident central bank as the world’s bank. The primary advantage here is being able to dictate global financial conditions, expanding and contracting money supply to address domestic and global funding pressures. As compensation for this task, the world provides one with non-negligible seigniorage revenue. Being the world’s central bank also comes with another crucial advantage: being able to choose which international projects will be funded, while using cheaply issued local debt to finance these investments. Of course, any sensible society will earn more on its investments than it pays on the debt issued. There is a geopolitical angle to having the world’s reserve currency. A nation’s currency is widely held because of strategic depth—its ability to secure the people who trade in that currency and the property denominated in it. Deposits and transactions can be monitored, secured, or even halted at the behest of the sovereign. Holding the currency means one can maintain one’s purchasing power, given that it is backed by the most powerful country in the world. As the reserve currency becomes the de facto international medium of exchange, having stood the test of time through various crises, this allows the resident country to alter its purchasing power to achieve both national and international goals. Throughout history, having the world’s reserve currency has been the pursuit of many governments and kingdoms. In the current paradigm, the US enjoys this privilege. But could that change? And if so, how and when? Our goal in this report is threefold. First, why would any country want to maintain reserve status? Second, does the US still possess the apparatus to keep the dollar as a reserve asset over the next decade? And finally, are there any identifiable threats to the US dollar reserve status beyond a ten-year horizon? The Imperative To Maintain Status Quo Global trade is still largely conducted in US dollars. According to the BIS triennial central bank survey, 88.3% of transactions globally were in dollars just before the pandemic, a percentage that has been rather resilient over the last two decades (Chart I-1). It is true that currencies such as the Chinese renminbi have been gaining international acceptance, but displacing a currency that dominates almost 90% of global transactions is a herculean task. Surprisingly, the world has been transacting less often in euros and Japanese yen, currencies that also commanded international appeal in recent history. Chart I-1The US Dollar Still Dominates Global Transactions Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The big benefit for the US comes from being able to settle its balance of payments in dollars. This not only lowers transaction costs (by lowering exchange rate risk), but it also provides the ability to cheaply borrow in your own currency to pay for imports. Having global trade largely denominated in US dollars also establishes a network of systems that make it much easier to settle trade in that currency. It is remarkable that, despite running a persistent current account deficit, the US dollar has tended to appreciate during crises, a privilege other deficit countries do not enjoy (Chart I-2). Strong network effects make the US dollar the currency of choice during crises. Chart I-2Despite Running A Current Account Deficit, The Dollar Tends To Rise During Crises Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-3The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue Being at the center of the global financial architecture comes with an important benefit beyond trade: the ability to dictate financial conditions both domestically and globally. Consider a scenario in which the US and the global economy are facing a downturn. In this scenario, the Federal Reserve can be instrumental in turning the tide: To stimulate the US economy, the Fed lowers interest rates and/or runs a wider fiscal deficit. The central bank helps finance this fiscal deficit by expanding the monetary base (benefitting from seigniorage revenue). As the Fed drops interest rates, the yield curve steepens. Banks use the positive term structure to borrow at the short end of the curve and lend at the longer end. This boosts the US money supply. As firms borrow to invest, this increases demand for imports (machinery, commodities, consumer goods), widening the US current account deficit. US trade is settled in dollars, increasing the international supply of the greenback. To maintain competitiveness, other central banks purchase these dollars from the private sector, in exchange for their local currency. As global USD reserves rise, they can be reinvested back into Treasuries and held in custody at the Fed. In essence, the US can finance its budget deficit through a strong capital account surplus. The seigniorage revenue that the US enjoys by easing both domestic and international financing conditions is about $100 billion a year or roughly 0.5% of GDP (Chart I-3). But the goodwill from being able to dictate both domestic and international financial conditions is far greater. At BCA, one of our favorite measures of global dollar liquidity is the sum of the Fed’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a financial crisis somewhere, typically among other countries running deficits (Chart I-4), a highlight of the importance of the US as a global financier. Chart I-4US Money Supply And Global Liquidity US Money Supply And Global Liquidity US Money Supply And Global Liquidity Chart I-5Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Beyond seigniorage revenue, the US enjoys another advantage—being able to earn much more on its international investments than it pays on its liabilities. The US generates an excess return of 1% of GDP from its external assets, despite having a net liability shortfall of 67% of GDP (Chart I-5). The ability to issue debt that will be gobbled up by foreigners, and in part use these proceeds to generate a higher overall return on investments made abroad, does indeed constitute an “exorbitant privilege.” In a nutshell, there is a very strong incentive for the US to keep the dollar as the world’s reserve currency. One short-term implication is that the Fed might only taper asset purchases and/or raise interest rates in an environment in which both global and US growth are strong, or it could otherwise trigger a global liquidity crisis. This will be particularly the case given the Delta variant of COVID-19 is still hemorrhaging global economic activity. An Overreach In The Dollar’s Influence There is a political advantage to the US dollar’s reserve status that is often overlooked: transactions conducted in US dollars anywhere in the world fall under US law. In simple terms, if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Since most companies across the world cannot afford to be locked out of the US financial system, they will tend to comply with US sanctions. Even companies that operate under the umbrella of great powers, such as China and Russia, still tend to adhere to US sanctions, because they do not want to jeopardize their trade with US allies, such as the European Union. Of course, China, Russia, and Iran are actively seeking alternative transaction systems to bypass the dollar and US sanctions. But they do not yet trust each other’s currencies. Chart I-6A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys The euro is the only viable alternative; however, the euro’s share of global transactions has fallen, despite the EU’s solidification as a monetary union over the past decade and despite the unprecedented deterioration of US relations with China and Russia. The EU could do great damage to the USD’s standing if it joined Russia’s and China’s efforts wholeheartedly, but the EU is still a major trading partner of the US and shares many of the same foreign policy aims. It is also chronically short of aggregate demand and runs trade and current account surpluses, depriving trade partners of euro savings or a debt market to recycle those savings (Chart I-6). Historically, having the world’s reserve currency allows the US to conduct international accords that serve both domestic and foreign interests. The Plaza Accord, signed in the 1980s to depreciate the US dollar, served both US interests in rebalancing the deficit and international interests in financing global trade. The 1980s were golden years for Japan and the Asian tigers on the back of a weak USD, allowing entities to borrow in greenbacks and profitably invest in Asian growth. Once the US dollar had depreciated by a fair amount, threatening its store of value, the US engineered the Louvre Accord to stabilize exchange rates. Ultimately, when various Asian bubbles popped, investors thought of nowhere better to flee than to the safety of the US dollar. The same thing happened after the emerging market boom of the 2000s and the eventual bust of the 2010s. Today, the US may not be able to organize an international intervention, if one should be necessary in the coming years. Past experience shows that countries act unilaterally and coordinated interventions lack staying power. Neither Europe nor Japan is in the position today to allow currency appreciation, as they were in the past. And the US has shown itself unable to combat its trading partners’ depreciation, as in the case of China, whose renminbi remains below 2014 levels. The bottom line is that there is nothing to stop the US from attempting to stretch its overreach too far, which would create a backlash that diminishes the dollar’s status. This is especially the case given trust in the US government is quite low by historical standards, which for now points to a lower dollar cyclically (Chart I-7). Chart I-7Trust In The US Government And The Dollar Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? This is not to say that other countries with reserve aspirations can tolerate sustained appreciation. China has recommitted to manufacturing supremacy in its latest five-year plan, as it fears the political consequences of rapid deindustrialization. As such, the renminbi will be periodically capped to maintain competitiveness. Can The US Maintain Status Quo? Chart I-8A Lifespan Of Reserve Currencies Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Over the last few centuries, reserve currencies have tended to have a lifespan of about 100 years (Chart I-8). The reason is that global wars tend to knock the leading power off its geopolitical pedestal, devaluing its currency and giving rise to a new peace settlement with a new ascendant country whose currency then becomes the basis for international trade. Such was the case for Spain, France, the UK, and the United States in a pattern of war and peace since the sixteenth century. Granting that the US dollar took the baton from sterling in the 1920s and that the post-World War II peace settlement is eroding in the face of escalating geopolitical competition, it is reasonable to ask whether or not the US might lose its grip on this power. To assess this possibility, it is instructive to revisit the anatomy of a reserve currency: Typically, a reserve currency tends to be that of the “greatest” nation. For the same reason, the reserve nation tends to be the wealthiest, which ensures that its currency is a store of value and that it can act as a buyer of last resort during crisis (Chart I-9). This reasoning is straightforward when a global empire is recognizable and unopposed. But in the current context of multipolarity, or great power competition, the paradigm could start to shift. Global trade is slowing globally, but it is accelerating in Asia (Chart I-10). China is a larger trading partner than the US for many emerging markets and is slated to surpass the US economy over the next decade. The renminbi has a long way to go to rival the dollar, but it is gradually rising and its place within the global reserve currency basket is much smaller than its share of global trade or output, implying room for growth (Chart I-11). Chart I-9Wealth And Reserve Currency Status Go Hand-In-Hand Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-10Trade In Asia Is Booming Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-11Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow To maintain hegemonic power (especially controlling the vital supply routes of prosperity), the reserve nation needs military might above and beyond everyone else. It helps that US military spending remains the biggest in the world, in part financed by US liabilities (Chart I-12). China is far from dethroning the US in the military realm. But it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Moreover, its naval power is set to grow substantially between now and 2030 (Table I-1). Already, over the past decade, the US stood helplessly by when Russia and China annexed Crimea and the reefs of the South China Sea. It is possible to imagine a series of events that erode US security guarantees in the region, even as the US loses economic primacy. Chart I-12The US Still Maintains Military Might Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Table I-1China’s Economic And Naval Growth Slated To Reduce American Primacy In Asia Pacific Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The reserve currency nation needs to run deficits to finance activity in the rest of the world. That requires having deep and liquid capital markets to absorb global savings. There is considerable trust or “goodwill” that makes the US Treasury market the most liquid debt exchange pool in the world. This remains the case today (previously mentioned Chart I-6). Even so, this trend is shifting. The growth in euro- and yen-denominated debt is exploding. This mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the US began to use the dollar as a geopolitical weapon recklessly, foreign entities may have no other choice but to rally into other currency blocks, including the euro (and perhaps eventually the yuan). This will take years, but it is worth noting that global allocation to FX reserves have fallen from around 80% toward USDs in the 70s to around 60% today (Chart I-13). Chart I-13The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing On the political front, there is some evidence that public opinion on the dollar is fading, although it is far from damning. A Pew survey on the trust in the US government is near decade lows and has tracked the ebb and flow of changes in the dollar (previously shown Chart I-7). Trust in government will probably not get much worse in the coming years, as the pandemic will wane and stimulus will secure the economic recovery, but too much stimulus could conceivably ignite an inflation problem that weighs on trust. True, populism has driven the US government under two administrations into extreme deficit spending. With the pandemic as a catalyst, US deficits have reached WWII levels despite the absence of a war. However, the Biden administration’s $3.5 trillion spending bill will be watered down heavily – and the 2022 midterms will likely restore gridlock in Congress, freezing fiscal policy through at least 2025. In other words, fiscal policy is negative for the dollar in the very near term, but the fiscal outlook is not yet so extravagant as to suggest a loss of reserve currency status. After all, there is some positive news for the US. The US demonstrated its leadership in innovation with the COVID-19 vaccines; it survived its constitutional stress test in the 2020 election; it is now shifting from failed “nation building” abroad to nation building at home; and its companies remain the most innovative and efficient, judging by global equity market capitalization (Chart I-14). China, meanwhile, is facing the most severe test of its political and economic system since it marketized its economy in 1979. Investors should not lose sight of the fact that, since the rise of President Xi Jinping and Russia’s invasion of Ukraine, global policy uncertainty has tended to outpace US policy uncertainty, attracting flows into the dollar (Chart I-15). Given that China and Russia are both pursuing autocratic governments at the expense of the private economy, it would not be surprising to see global policy uncertainty take the lead once again, confirming the decade trend of global flows favoring the US when uncertainty rises. Chart I-14American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market Chart I-15Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar The bottom line is that the US dollar is gradually declining as a share of the global currency reserve basket, just as the US economy and military are gradually declining as a share of global output and defense spending. Yet the US will remain the first or second largest economy and premier military power for a long time, and the dollar still lacks a viable single replacement. A major war or geopolitical crisis is probably necessary to precipitate a major breakdown. The Iranian Revolution and September 11 attacks both had this kind of effect (see 1979 and 2001 in Chart I-13 above). But COVID-19 is less clear. If China and Europe emerge as more stable than the US, then the post-pandemic aftermath will bring more bad news for the dollar. Investment Implications From a geopolitical perspective, the backdrop is neutral for the dollar beyond the next twelve to eighteen months. An escalating conflict with Iran—which is possible in the near term—would echo the early 2000s and weigh on the currency. But a deal with Iran and a strategic pivot to Asia would compound China’s domestic political problems and likely boost the greenback. Chart I-16US Twin Deficits And The Dollar US Twin Deficits And The Dollar US Twin Deficits And The Dollar From a macro and cyclical perspective, however, the view is clearly negative for the dollar. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will shrink and then begin expanding again to -5% of GDP. If one assumes that the current account deficit will widen somewhat, then stabilize, the twin deficits will be pinned at around -10% of GDP. Markets have typically punished the dollar on rising twin deficits (Chart I-16). This suggests near-term pressure on the dollar’s reserve status is to the downside. EM currencies may hold a key to the performance of the dollar. While most EM economies remain hostage to the virus, a coiled-spring rebound cannot be ruled out as populations become vaccinated. China’s Politburo signaled in July that it will no longer tighten monetary and fiscal policy. We would expect policy easing over the next twelve months to ensure the economy is stable in advance of the fall 2022 party congress. If the virus wanes and China’s economy is stimulated, global growth will improve and the dollar will fall.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com

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