Technology

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

Strong Connnection Strong Connnection Overweight The juggernaut trend in the US software & services industry is as strong as ever, and today we are reiterating our overweight call for this large sector. First, within the context of our recent recommendation to rotate into growth, software & services stocks are quintessential growth companies that outperform during periods of a growth slowdown and benefit from rate stabilization. Second, the US private fixed investment in software is going to the moon with the latest print making a 20-year high (top panel). There is no doubt that all this capex will boost both top-line and bottom-line growth. Finally, software & services earnings growth expectation data is also revealing. Sell-side analysts have completely thrown in the towel on software companies with relative forward earnings probing dotcom and GFC era Mariana Trenches (bottom panel). Bottom Line: Secular software & services growth story remains intact and we reiterate our overweight recommendation for this key sector.  

Highlights Tactically downgrade cyclical equities from overweight in Europe. The shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries create headwinds for the cyclicals-to-defensives ratio this summer. Weaker global inflation expectations, commodity prices, and a dollar rebound will accompany this period of turbulence. The relative technical and valuation backdrop will also contribute to this period. Short consumer discretionary / long telecommunication is a high-octane version of the trade. Short technology / long healthcare is its lower-risk / lower-reward cousin. This temporary portfolio shift is a risk management move to capitalize on our positive 18- to 24- month view on cyclicals. Feature Last week, we recommended investors adopt a more defensive tactical posture.  They should raise cash and shift into defensive quality names in order to weather a summer replete with potential downside risk. This will place investors in a good position to shift back into a more aggressive stance this fall, when cyclical sectors should resume their outperformance. This week, we explore this idea in more detail. The combination of a Chinese credit slowdown, a potential transition in the driver of growth away from goods into services, and a shift in tone from global central banks will feed the expected market volatility this summer. European defensive stocks are set to outperform during this period. Buying telecommunication equities / selling consumer discretionary stocks is a high octane bet on this trend, while going long healthcare / short technology shares is its low-risk incarnation. Summer Storms This summer, three forces will feed some downside risk in the market and, more specifically, an underperformance of cyclical sectors relative to defensive ones: a transition in global growth, preliminary signs that global central banks will begin to take away the punch bowl, and disappointments caused by COVID variants. Growth Transition The global economy is set to cool down as we transition away from the first stage of the post-pandemic recovery. As we showed last week, China’s deteriorating credit impulse is consistent with global industrial activity receding from its extremely robust pace of expansion (Chart 1). The continued decline in China’s banking system excess reserve ratio suggests that total social financing flows will slow further. Consequently, China’s intake of raw materials and industrial goods will decelerate, which will impact global industrial activity negatively. Already, the New Orders component of China’s Manufacturing PMI has rolled over. The disappointment of Chinese retail sales last week further indicates that China will act as a drag on global growth in the coming quarters. We have also highlighted that the combined effect of higher yields and oil prices has become strong enough to alter negatively the path of global industrial activity going forward. Our Global Growth Tax indicator, which includes both variables, shows that the US ISM Manufacturing survey and the global manufacturing PMI have reached their apex and will moderate this summer (Chart 2). Chart 1The China Drag The China Drag The China Drag Chart 2Rising Costs Bite Rising Costs Bite Rising Costs Bite The problem for global growth is one of changing leadership. Global economic activity is not about to collapse, but the extraordinary surge in goods consumption that started in 2020 will make room for a catch-up in the service sector. As an example, US retail sales stand 15% above their pre-pandemic trends; however, services spending still lies 7% below its pre-pandemic tendency (Chart 3). Thus, as summer progresses, the recent deceleration in consumer spending on goods will continue and services will progressively pick up the slack. The change in growth leadership will cause some temporary trepidation in global economic activity, because it is happening when the effect of both the Chinese credit slowdown and the previous increase in yields and oil will be most potent. As a result, we expect the G-10 Economic Surprises Index to follow that of China and experience an air pocket this summer (Chart 4). Chart 3From Goods To Services From Goods To Services From Goods To Services Chart 4Where China Goes, So Will The G-10 Where China Goes, So Will The G-10 Where China Goes, So Will The G-10   The Chaperone Is On The Way More than 65 years ago, former Fed Chair William McChesney Martin noted that the job of central bankers was to be “the chaperone who has ordered the punch bowl removed just as the party was really warming up.” Chart 5The Chaperone Is Waking Up The Chaperone Is Waking Up The Chaperone Is Waking Up Today, the party is a rager, and central bankers are indicating that they will remove the punch bowl soon. Real estate speculation is worrying the Bank of Canada, and its balance sheet has already shrunk by C$99 billion, to C$476 billion. The Norges Bank has indicted that it will lift interest rates twice this year. The Reserve Bank of New Zealand is set to lift the Official Cash Rate soon. The Bank of England has begun to adjust its asset purchases and could begin a full-fledge tapering this year. The 800-pound gorilla is the Fed, which telegraphed more clearly last week its intention to raise rates twice in 2023, and therefore moved closer to the pricing of the OIS curve (Chart 5). Implied in this forecast, the Fed will start tapering its asset purchase in early 2022 at the latest. This change in tone by global central banks is not a major problem for the business cycle – global rates are still far below any reasonable estimates of the neutral rate of interest, but periods of transition in monetary policy are often associated with transitory market turbulences. This time will not be an exception, especially because it is happening when global growth is downshifting. Delta, Gamma, Epsilon, etc? Chart 6Depressed Macro Volatility Depressed Macro Volatility Depressed Macro Volatility With the rapid progress of vaccination, the worst of the COVID tragedy is behind us. Nonetheless, the pandemic is not yet fully in the rear-view mirror, not even in the Western nations that lead the global inoculation campaign. SARS-CoV-2 continues to evolve and will therefore produce new variants over time, some of which will be problematic. The UK illustrates this phenomenon. The government has postponed the so-called Freedom Day, when life returns to normal, by five weeks despite the country’s high vaccination rate. The Delta variant is significantly increasing among the unvaccinated and not fully inoculated Britons. Many countries will also face this problem. These delays will be minor and will not threaten national recoveries. However, they will feed market tensions in a context where global macro volatility is low (Chart 6), global growth is already peaking, and monetary accommodation is receding. Global Market Implications… The confluence of the change in global economic growth leadership, the upcoming liquidity removal, and the potential for short-lived delays to the global economic re-opening point toward a decline in global inflation expectations, a rebound in the US dollar, weaker commodity prices, and an underperformance of global cyclical relative to defensive equities. Over the coming months, inflation breakeven rates are likely to soften, while real yields will rise modestly. In May, US inflation breakeven rates peaked near 2.6%, their highest level in ten years. A weaker global growth impulse in combination with a Fed that is more willing to remove some monetary accommodation will cool inflationary fears among investors and cause inflation expectations to decline further. However, the specter of tighter policy will also support TIPS yields. Bond yields are likely to correct somewhat more over the summer. Bond prices have not yet fully purged their oversold conditions (Chart 7); thus, a decrease in inflation expectations will temporarily support Treasury prices, even if real yields do not fall. Recent market action is moving in this direction. Last week, by Thursday evening, 10-year Treasury yields had already lost their 9 bps rise that followed Wednesday’s FOMC meeting. 30-year Treasury yields have plunged to a four-month low. Bund yields are unable to hang on to their gains either. The dollar has more upside this summer. Higher real US yields offer a potent backing for a DXY that still refuses to drop below 89. Moreover, the greenback is a highly counter-cyclical currency and is particularly sensitive to the gyrations in the global industrial cycle. Thus, the deceleration in the global manufacturing cycle will create a temporary tailwind for the greenback. Over the past three years, the gap between US TIPS yields and the Chinese Economic Surprise index explained the fluctuation of the DXY; it currently points toward a continued rebound in the USD (Chart 8). Even if this move is ephemeral, it will have implications for investors this summer. Chart 7Technical Backdrop For Bonds Technical Backdrop For Bonds Technical Backdrop For Bonds Chart 8Near-Term Upside For The DXY Near-Term Upside For The DXY Near-Term Upside For The DXY Commodities will also suffer. Natural resource prices have rallied in a parabolic fashion and our Composite Technical Indicator is massively overbought (Chart 9). Meanwhile, Chinese authorities are verbally jawboning industrial metal prices and have begun to release copper, zinc, aluminum, and nickel from their stockpiles. In this context, the Chinese credit slowdown and the imminent removal of monetary accommodation in various corners of the globe will catalyze a correction in commodities, even if a new supercycle has begun. The recent travails of lumber prices, which have collapsed 47% since May 7 (while they still remain in technical bull market!), may constitute a canary in the coalmine for the wider commodity complex. Global cyclical equities have greater downside against their defensive counterparts. US markets are global trendsetters; while the S&P cyclicals have lost some altitude compared to defensives, they have yet to purge their oversold state and remain very expensive (Chart 10). This backdrop makes them vulnerable to slowing Chinese import growth, a stronger dollar, and weaker commodity prices. Chart 9Will The GSCI Follow Lumber? Will The GSCI Follow Lumber? Will The GSCI Follow Lumber? Chart 10Vulnerable Global Cyclicals Vulnerable Global Cyclicals Vulnerable Global Cyclicals   … And European Investment Implications Chart 11European Cyclicals Are Also At Risk European Cyclicals Are Also At Risk European Cyclicals Are Also At Risk The European cyclicals-to-defensives ratio is vulnerable, like it is in the US. Hence, a more defensive portfolio bias makes sense for the summer, which should allow investors to regain maximum cyclical exposure later this year. Short consumer discretionary / long telecommunications and short technology / long healthcare are pair trades with particularly attractive risk profiles. The cyclicals-to-defensives ratio is technically unattractive. The relative share prices stand toward the top of their 16-year trading range (Chart 11). Moreover, their 52-week momentum measure is rolling over at a highly elevated level, while the 13-week rate of change is deteriorating. Meanwhile, the Combined Mechanical Valuation Indicator1 (CMVI) of the cyclicals towers far above that of the defensives and is consistent with a corrective episode (Chart 11, bottom panel). The drivers of the performance of Eurozone cyclical relative to defensive sectors confirm that cyclicals could suffer a turbulent summer. For instance: The potential for further declines in global yields does not bode well for the European cyclicals-to-defensives ratio (Chart 12). Weaknesses in market-based inflation expectations would prove particularly threatening (Chart 12, bottom panel). The deceleration in China’s total social financing flows anticipates an underperformance of European cyclicals (Chart 13). As China’s credit decelerates, so will the earnings revisions of cyclical equities. Moreover, a weaker Chinese TSF is consistent with falling Treasury yields. Chart 12Lower Inflation Expectations Equals Underperforming Cyclicals Lower Inflation Expectations Equals Underperforming Cyclicals Lower Inflation Expectations Equals Underperforming Cyclicals Chart 13Cyclicals Listen To China Cyclicals Listen To China Cyclicals Listen To China The potential for weaker commodity prices is another problem for European cyclical equities (Chart 14). Commodities capture the ebb and flow of global growth sentiment, which is also a driver of the earnings revisions of cyclicals relative to defensives. Moreover, commodity prices greatly affect the earnings of cyclical equities. Unsurprisingly, the momentum of the European cyclicals-to-defensives ratio correlates closely with the BCA Commodity Composite Technical Indicator (Chart 14, bottom panel). Cyclicals perform poorly when the dollar appreciates. The Eurozone’s cyclicals-to-defensives ratio moves in lock-step with the euro and high-beta cyclical currencies (Chart 15). These relationships reflect the counter-cyclicality of the dollar, as well as the negative effect on global financial conditions of its rallies, and thus, on the earnings outlook for cyclicals. Chart 14Beware The Impact Of Weaker Commodities Beware The Impact Of Weaker Commodities Beware The Impact Of Weaker Commodities Chart 15A Strong Dollar Hurts European Cyclicals A Strong Dollar Hurts European Cyclicals A Strong Dollar Hurts European Cyclicals Chart 16Short Consumer Discretionary And Long Telecommunication Short Consumer Discretionary And Long Telecommunication Short Consumer Discretionary And Long Telecommunication Based on these observations, we are tactically downgrading cyclicals from our overweight stance for the summer, despite our conviction that cyclicals have upside on an 18- to 24-month basis. We look at this move as risk management. For investors looking to bet on a potential underperformance of cyclical equities in Europe, we recommend two positions: a high-octane pair trade and a lower-risk one. The high-octane version is to sell consumer discretionary stocks and buy telecommunications ones (Chart 16). This pair trade is exposed to lower yields, lower inflation expectations, and the shift in growth drivers from China and goods consumption to services expenditures. Additionally, the relative 52-week momentum measure is overextended, while the 13-week rate of change is already sagging. The CMVI of the consumer discretionary sector is extremely elevated, while that of telecommunication stocks is the most depressed of any Eurozone sector. Consequently, the gap between the two sectors’ CMVI stands at nearly three-sigma, which is concerning because the RoE of consumer discretionary shares lies 7% below that of the telecoms industry (Chart 16, third and fourth panel). Because higher RoEs should justify higher valuations, consumer discretionary and telecommunication stand out as the greatest outliers among European sectors (Chart 17). As an added benefit, this trade enjoys a positive dividend carry of more than 2.5%. Chart 17Spot The Outliers Summertime Blues Summertime Blues Chart 18Short Technology And Long Healthcare Short Technology And Long Healthcare Short Technology And Long Healthcare The low octane pair trade is to sell technology stocks and buy healthcare names instead. This position offers lower expected returns but also a lower risk, because both sectors are growth stocks and they will benefit from falling yields and inflation expectations. However, based on their respective CMVI, tech equities are much more expensive than healthcare ones (Chart 18), while they are also extremely overbought. Thus, healthcare should benefit more from falling yields and inflation expectations than tech. Moreover, technology is a more cyclical sector than healthcare; it will therefore be more sensitive to the evolution of global growth. Bottom Line: We remain positive on the outlook for cyclical equities on an 18- to 24-month horizon, but the changing global growth leadership, the imminent removal of global monetary accommodation, and the demanding valuation and technical backdrop of the European cyclicals-to-defensives ratio suggest that a period of turbulence will materialize this summer. Thus, we are tactically downgrading cyclicals. Investors should consider going long telecommunications / short consumer discretionary as a high-octane tactical bet on this portfolio stance. Buying healthcare / selling technology would constitute a lower risk / lower return play. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Footnotes 1 For a detailed explanation of the Combined Mechanical Valuation Indicator, see Special Report, “Valuation – A Mechanical Approach,” dated May 31, 2021. Currency Performance Summertime Blues Summertime Blues Fixed Income Performance Government Bonds Summertime Blues Summertime Blues Corporate Bonds Summertime Blues Summertime Blues Equity Performance Major Stock Indices Summertime Blues Summertime Blues Geographic Performance Summertime Blues Summertime Blues Sector Performance Summertime Blues Summertime Blues

Dear Client, Last week, I had the pleasure of participating in a debate with my colleague, Dhaval Joshi, on the future of cryptocurrencies. You can access a replay of the event here. Best regards, Peter Berezin Highlights The meme stock mania is unlikely to die down anytime soon. Fueled by zero-commission trading and an anti-establishment mindset, social media has given millions of retail traders the ability to coordinate attacks on individual companies. An examination of the most popular meme stocks reveals that returns were highest when both the closing price and volume during the prior day’s session were above their moving averages. For GameStop and AMC, in particular, returns averaged 11.0% and 13.9%, respectively, when both the prior day’s closing price and volume were above their 5-day moving averages, compared with -4.0% and -1.3%, respectively, when the price and volume were below their 5-day moving averages. Nearly 80% of the returns on meme stocks were earned overnight (i.e., between the close of trading and the following day’s open). The ups and downs of meme stocks have generally had little impact on the overall direction of the stock market. Nevertheless, growing interest in meme stocks is positive for equities over a medium-term horizon of about 12 months. This is because the meme stock phenomenon is drawing funds into the stock market, boosting prices and liquidity in the process. #HedgiesGetWedgies Chart 1Word Du Jour: Meme Word Du Jour: Meme Word Du Jour: Meme This January, the term “meme stock” entered the popular lexicon (Chart 1). That was the month that GameStop and a handful of other once-left-for-dead stocks soared to dizzying heights. Armed with stimulus checks, millions of amateur investors flocked to one of the few sources of entertainment still available to them: online trading. Tales of instant riches spread like wildfire, motivating yet more new investors to enter the fray. Whether it was stocks or cryptos, the allure of easy money was irresistible. The decision by most American brokerages to eliminate trading commissions in the fall of 2019 added fuel to the fire. Meanwhile, the proliferation of social media provided a ready-made mechanism for retail traders to coordinate attacks on individual stocks. And attack they did. Most of the companies targeted had high short interest, making them ripe for a short squeeze. The implosion of Melvin Capital demonstrated to the Reddit crowd that they, too, could beat hedge funds at their own game. “We can remain stupid longer than you can stay solvent” became their rallying cry. In a game of chicken, being perceived by your opponent as irrational boosts your odds of winning. Trading Meme Stocks For Fun And Profit If one were so inclined, how should one trade meme stocks? It helps to begin with some data. Table 1 displays average daily returns from the start of 2021 for six popular meme stocks: GameStop (GME), AMC Entertainment (AMC), Blackberry (BB), Nokia (NOK), Bed Bath & Beyond (BBBY) and Koss Corp (KOSS). A few observations stand out: There is strong price momentum. Looking across all six stocks, the average daily return was 5.9% when the prior day’s closing price was above its 5-day moving average, compared to 0.3% when the prior day’s close was below its 5-day moving average. The average daily return for stocks in our sample was 3.3%. Volatility predicts higher returns. Meme stocks gained 4.3%, on average, when the prior day’s return was positive compared to 2.4% when it was negative. Looking only at the subset of cases where the prior day’s return was either above 10% or below -10%, we find that meme stocks gained 11.3% when the price rose more than 10% during the prior day and gained a still-robust 7.5% when the price dropped more than 10% during the prior day. Strong volume predicts higher returns. Consistent with the volatility observation, meme stocks gained an average of 6.1% when the volume in the prior day’s trading session was above its 5-day moving average, compared to just 1.3% when the volume was below its 5-day moving average. Meme stocks do best after the close of trading. Nearly 80% of returns on meme stocks were earned overnight (i.e., between the close of trading and the following day’s open). We attribute this phenomenon to the tendency of many traders to exit positions before the closing bell and reopen them at the start of trading the following day. Such a pattern of selling and repurchasing tends to boost overnight returns. Historically, a similar pattern has held for most other US stocks (Chart 2). Table 1Meme Stock: Returns And Patterns To The Moon: How To Trade Meme Stocks To The Moon: How To Trade Meme Stocks Chart 2Bear By Day, Bull By Night To The Moon: How To Trade Meme Stocks To The Moon: How To Trade Meme Stocks In summary, meme stocks perform best when they are trading above their 5-day moving average. Both volatility and strong volume predict positive returns. Holding (hodling?)1 meme stocks overnight can significantly enhance returns. Be An Ape Chart 3The BUZZ ETF Is Off To A Lackluster Start The BUZZ ETF Is Off To A Lackluster Start The BUZZ ETF Is Off To A Lackluster Start Fans of AMC often refer to themselves as “apes.” The moniker is fitting, if not ironic, given the tendency of meme investors to ape one another in their trading decisions. The VanEck Vectors Social Sentiment ETF (BUZZ) tries to get in front of the apes and other meme investors by buying stocks that are garnering increasing attention from social media, news articles, blog posts, and other sources. While it is too early to assess the value of this approach, it should be noted that the fund has lagged the S&P 500 for most of the time since its inception in March (Chart 3). A potentially more fruitful approach, and one that I myself have adopted, is to seek out meme stocks before they become meme stocks. For example, Cinemark (CNK) is the second biggest publicly-listed movie theater chain in the US. The share of its float sold short is almost identical to AMC’s. Yet, the Reddit crowd has largely ignored it. Could that change? Only time will tell. Don’t Get A Wedgie: How To Short Meme Stocks Safely While meme stocks can benefit from positive price momentum in the short term, it is at the expense of lower returns down the road. By any reasonable measure, the leading meme stocks are grossly overvalued. Knowing when a meme stock will fall back to earth is no easy task, however. The discussion in this report provides one avenue for short-term traders to mitigate risk: Short meme stocks only when price and volume are trending lower. The average daily return for GME and AMC was 11.0% and 13.9%, respectively, when both the prior day’s closing price and volume were above their 5-day moving averages, compared with -4.0% and -1.3%, respectively, when the price and volume were below their 5-day moving averages. With that in mind, we are opening a new tactical trade going short an equally-weighted basket of AMC and GME. The trade will only be active when the prior day’s closing price and volume are below their 5-day moving averages.2  Longer-term investors looking to short meme stocks without having to frequently open and close positions should consider using the “exponential” shorting technique discussed in a recent report. The technique flips the usual risk-reward trade-off from going short on its head. Rather than facing unlimited losses and a maximum gain of only 100% of the initial position, our shorting strategy caps the loss at 100% but allows for unlimited gains. Broad Market Implications As Chart 4 illustrates, the ups and downs of meme stocks have generally had little impact on the overall direction of the stock market. Nevertheless, growing interest in meme stocks is positive for equities over a medium-term horizon of about 12 months. This is because the meme stock phenomenon is drawing funds into the stock market, boosting prices and liquidity in the process. Chart 4Meme Stock Roller-Coaster: Little Impact On The Broader Market Meme Stock Roller-Coaster: Little Impact On The Broader Market Meme Stock Roller-Coaster: Little Impact On The Broader Market Chart 5Global Equity Risk Premium Remains Quite High Global Equity Risk Premium Remains Quite High Global Equity Risk Premium Remains Quite High   While the “stimmy” checks have already been deposited into brokerage accounts, their impact on the stock market will linger on. As we explained in Savings Gluts, Asset Shortages, And The 60/40 Split, retail investors who bid up the price of stocks will generally force institutional investors to sell their holdings.3 This will leave institutions with excess cash on hand – cash that they can deploy in other parts of the stock market. The resulting game of “hot potato” will only end when the value of the stock market rises by enough to ensure that all investors are happy with how much stock they own in relation to how much cash they hold. Given that the equity risk premium remains quite high, this dynamic likely has further to run (Chart 5). Disclosure: At the time of writing, I am personally long CNK and short AMC and GME. I previously held a short position in KOSS. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1 HODL stands for “Hold On for Dear Life”. The term is widely used by traders on Wallstreetbets and other online forums. 2 The equal-weighted trade should be initiated if the conditions are met for either stock (GME, AMC) in the basket. The conditions are as follows: Both the price and volume should be below their 5-day moving average. The price and volume at the end of the day determine whether one enters the trade the next day or not. 3 An exception is when retail investors buy stock from the company itself, as has happened several times with meme stocks. Global Investment Strategy View Matrix To The Moon: How To Trade Meme Stocks To The Moon: How To Trade Meme Stocks Special Trade Recommendations To The Moon: How To Trade Meme Stocks To The Moon: How To Trade Meme Stocks Current MacroQuant Model Scores To The Moon: How To Trade Meme Stocks To The Moon: How To Trade Meme Stocks  

Highlights Political and corporate climate activism will increase the cost of developing the resources required to produce and deliver energy going forward – e.g., oil and gas wells; pipelines; copper mines, and refineries. Over the short run, the fastest way for investor-owned companies (IOCs) to address accelerated reductions in CO2 emissions imposed by courts and boards is to walk away from the assets producing them, which could be disruptive over the medium term. Longer term, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources needed to produce and distribute energy. The real difficulty will come in the medium term. Capex for critical metals like copper languishes, just as the call on these metals steadily increases over the next 30 years (Chart of the Week). The evolution to a low-carbon future has not been thought through at the global policy level. A real strategy must address underinvestment in base metals and incentivize the development of technology via a carbon tax – not emissions trading schemes – so firms can innovate to avoid it. We remain long energy and metals exposures.1 Feature And you may ask yourself, "Well … how did I get here?" David Byrne, Once In A Lifetime Energy markets – broadly defined – are radically transforming from week to week. The latest iteration of these markets' evolution is catalyzed by climate activists, who are finding increasing success in court and on corporate boards – sometimes backed by major institutional investors – and forcing oil and gas producers to accelerate CO2 emission-reduction programs.2 Climate activists' arguments are finding increasing purchase because they have merit: Years of stiff-arming investors seeking clarity on the oil and gas producers' decarbonization agendas, coupled with a pronounced failure to provide returns in excess of their cost of capital, have given activists all of the ammo needed to argue their points. Chart of the WeekCall On Metals For Energy Will Increase A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way This activism is not limited to the courts or boardrooms. Voters in democratic societies with contested elections also are seeking redress for failures of their governments to effectively channel mineral wealth back into society on an equitable basis, and to protect their environments and the habitats of indigenous populations. This voter activism is especially apparent in Chile and Peru, where elections and constitutional conventions likely will result in higher taxes and royalties on metals IOCs operating in these states, which will increase production costs and ultimately be passed on to consumers.3 These states account for ~ 40% of world copper output. IOCs Walk Away Earlier this week, Exxon walked away from an early-stage offshore oil development project in Ghana.4 This followed the unfavorable court rulings and boardroom setbacks experienced by Royal Dutch Shell, Chevron and Exxon recently (referenced in fn. 2). While the company had no comment on its abrupt departure, its action shows how IOCs can exercise their option to put a project back to its host government, thus illustrating one of the most readily available alternatives for energy IOCs to meet court- or board-mandated CO2 emissions targets. If these investments qualify as write-offs, the burden will be borne by taxpayers. As climate activism increases, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources – particularly oil and gas – needed to produce and distribute energy going forward. This is not an unalloyed benefit, as the SOCs still face stranded-asset risks, if they invest in longer-lived assets that are obviated by a successful renewables + grid buildout globally. That is a cost that will have to be compensated, when the SOCs work up their capex allocations. Still, if legal and investor activism significantly accelerates IOCs' capex reductions in oil and gas projects, the SOCs – particularly those in OPEC 2.0 – will be able to expand their position as the dominant supplier in the global oil market, and could perhaps increase their influence on price levels and forward-curve dynamics (Chart 2).5 Chart 2OPEC 2.0s Could Expand If Investor Activism Increases OPEC 2.0s Could Expand If Investor Activism Increases OPEC 2.0s Could Expand If Investor Activism Increases Higher Call On Metals At present, there is a lot of talk about the need to invest in renewable electricity generation and the grid structure supporting it, but very little in the way of planning for this transition. Other than repeated assertions of its necessity, little is being said regarding how exactly this strategy will be executed given the magnitude of the supply increase in metals required. Nowhere is this more apparent than in the refined copper market, which has been in a physical deficit – i.e., production minus consumption is negative – for the last 6 years (Chart 3). Physical copper markets in China, which consumes more than 50% of refined output, remain extremely tight, as can be seen in the ongoing weakness of treating charges and refining charges (TC/RC) for the past year (Chart 4). These charges are inversely correlated to prices – when TC/RCs are low, it means there is surplus refining capacity for copper – unrefined metal is scarce, which drives down demand for these services. Chart 3Coppers Physical Deficit Likely Persist Coppers Physical Deficit Likely Persist Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains Tight Chinas Refined Copper Supply Remains Tight Chinas Refined Copper Supply Remains Tight Theoretically, high prices will incentivize higher levels of production. However, after the last decade’s ill-timed investment in new mine discoveries and expansions, mining companies have become more wary with their investments, and are using earnings to pay dividends and reduce debt. This leads us to believe that mining companies will not invest in new mine discoveries but will use capital expenditure to expand brownfield projects to meet rising demand. In the last decade, as copper demand rose, capex for copper rose from 2010-2012, and fell from 2013-2016 (Chart 5). During this time, the copper ore grade was on a declining trend. This implies that the new copper brought online was being mined from lower-grade ore, due to the expansion of existing projects(Chart 6). Chart 5Copper Capex Growth Remains Weak A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way Capex directed at keeping ore production above consumption will not be sufficient to avoid major depletions of ore supplies beginning in 2024, according to Wood Mackenzie. The consultancy foresees a cumulative deficit of ~ 16mm MT by 2040. Plugging this gap will require $325-$500 billion of investment in the copper mining sector.6 The Case For A Carbon Tax The low-carbon future remains something of a will-o'-the-wisp – seen off in the future but not really developed in the present. Most striking in discussions of the low-carbon transition is the assumption of resource availability – particularly bases metals –in, e.g., the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector, published last month. In the IEA's document, further investment in hydrocarbons is not required beyond 2025. The copper, aluminum, steel, etc., required to build the generation and supporting grid infrastructure will be available and callable as needed to build all the renewable generation the world requires. The document is agnostic between carbon trading and carbon taxes as a way to price carbon and incentivize the technology that would allow firms and households to avoid a direct cost on carbon. A real strategy must address the fact that most of the world will continue to rely on fossil fuels for decades, as development goals are pursued. Underinvestment in base metals and its implications for the buildout of generation and grids has to be a priority if these assets are to be built. Given the 5-10-year lead times base metals mines require to come online, it is obvious that beyond the middle of this decade, the physical reality of demand exceeding supply will assert itself. A good start would be a global effort to impose and collect carbon taxes uniformly across states.7 This would need to be augmented with a carbon club, which restricts admission and trading privileges  to those states adopting such a scheme. Harmonizing the multiple emissions trading schemes worldwide will be a decades-long effort that is unlikely to succeed. Such schemes also can be gamed by larger players, producing pricing distortions. A hard and fast tax that is enforced in all of the members of such a carbon club would immediately focus attention on the technology required to avoid paying it – mobilizing capital, innovation and entrepreneurial drive to make it a reality. This would support carbon-capture, use and storage technologies as well, thus extending the life of existing energy resources as the next generation of metals-based resources is built out. In addition, a carbon tax raises revenue for governments, which can be used for a variety of public policies, including reducing other taxes to reduce the overall burden of taxation. Lastly, a tax eliminates the potential for short-term price volatility in the pricing of carbon – as long as households and firms know what confronts them they can plan around it.  Tax revenues also can be used to reduce the regressive nature of such levies. Investment Implications The lack of a coherent policy framework that addresses the very real constraints on the transition to a low-carbon economy makes the likelihood of a volatile, years-long evolution foreordained. We believe this will create numerous investment opportunities as underinvestment in hydrocarbons and base metals production predisposes oil, natural gas and base metals prices to move higher in the face of strong and rising demand. We remain long commodity index exposure – the S&P GSCI and GSCI Commodity Dynamic Roll Strategy ETF (COMT), which is optimized to take advantage of the most backwardated commodity forward curves in the index. These positions were up 5.3% and 7.2% since inception on December 7, 2017 and March 12, 2021, respectively, at Tuesday's close. We also remain long the MSCI Global Metals & Mining Producers ETF (PICK), which is up 33.9% since it was put on December 10, 2020. Expecting continued volatility in metals – copper in particular – we will look for opportunities to re-establish positions in COMEX/CME Copper after being stopped out with gains. A trailing stop was elected on our long Dec21 copper position established September 10, 2020, which was closed out with a 48.2% gain on May 21, 2021. Our long calendar 2022 vs short calendar 2023 COMEX copper backwardation trade established April 22, 2021, was closed out on May 20, 2021, leaving us with a return of 305%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 offered no surprises to markets this week, as it remained committed to returning just over 2mm b/d of production to the market over the May-July period, 70% of which comes from the Kingdom of Saudi Arabia (KSA), according to Platts. While Iran's return to the market is not a given in OPEC 2.0's geometry, we have given better than even odds it will return to the market beginning in 3Q21 and restore most of the 1.4mm b/d not being produced at present to the market over the course of the following year. OPEC itself expects demand to increase 6mm b/d this year, somewhat above our expectation of 5.3mm b/d. Stronger demand could raise Brent prices above our average $63/bbl forecast for this year (Chart 7). Brent was trading above $71/bbl as we went to press. Base Metals: Bullish BHP declared operations at its Escondida and Spence mines were running at normal rates despite a strike by some 200 operations specialists. BHP is employing so-called substitute workers to conduct operation, according to reuters.com, which also reported separate unions at both mines are considering strike actions in the near future. Precious Metals: Bullish The Fed’s reluctance to increase nominal interest rates despite indications of higher inflation will reduce real rates, which will support higher gold prices (Chart 8). We agree with our colleagues at BCA Research's US Bond Strategy that the Fed is waiting for the US labor market to reach levels consistent with its assessment of maximum employment before it makes its initial rate hike in this interest-rate cycle. Subsequent rate changes, however, will be based on realized inflation and inflation expectations. In our opinion, the Fed is following this ultra-accommodative monetary policy approach to break the US liquidity trap, brought about by a rise in precautionary savings due to the pandemic. In addition, we continue to expect USD weakness, which also will support gold and precious metals prices. We remain long gold, expecting prices to clear $2,000/oz this year. Ags/Softs: Neutral Corn prices fell more than 2% Wednesday, following the release of USDA estimates showing 95% of the corn crop was planted by 31 May 2021, well over the 87% five-year average. This was in line with expectations. However, the Department's assessment that 76% of the crop was in good-to-excellent condition exceeded market expectations. Chart 7 By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 8 Gold Prices Going Up Gold Prices Going Up Footnotes 1     Please see Trade Tables below. 2     Please see OPEC, Russia seen gaining more power with Shell Dutch ruling and EXCLUSIVE BlackRock backs 3 dissidents to shake up Exxon board -sources published by reuters.com June 1, 2021 and May 25, 2021. 3    Please see Chile's govt in shock loss as voters pick independents to draft constitution published by reuters.com May 17, 2021, and Peru’s elite in panic at prospect of hard-left victory in presidential election published by ft.com June 1, 2021.  Peru has seen significant capital flight on the back of these fears.  See also Results from Chile’s May 2021 elections published by IHS Markit May 21, 2021 re a higher likelihood of tax increases for the mining sector.  The risk of nationalization is de minimis, according to IHS. 4    Please see Exxon walks away from stake in deepwater Ghana block published by worldoil.com June 1, 2021. 5    Please see OPEC 2.0's Production Strategy In Focus, which we published on May 20, 2021, for a recap our how we model OPEC 2.0's strategy.  It is available at ces.bcaresearch.com. 6    Please see Will a lack of supply growth come back to bite the copper industry?, published by Wood Mackenzie on March 23, 2021. 7     Please see The Challenges and Prospects for Carbon Pricing in Europe published by the Oxford Institute for Energy Studies last month for a discussion of carbon taxes vs. emissions trading schemes.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Underweight Beware: Communications Equipment Value Trap Beware: Communications Equipment Value Trap Our underweight in the S&P communications equipment index is slightly in the green, and today we reiterate our below benchmark allocation in this niche tech sub-sector. The key reason for concern is industry pricing power. While the US economy is inflating on nearly every metric, communications equipment manufacturers are struggling to keep up, and their relative pricing power is sinking like a stone (second panel).  In fact, year-over-year (y/y) growth for CSCO’s enterprise orders is at the 0% mark. Keep in mind that Q1/2020 is the earliest quarter that the pandemic started to wreak havoc, yet CSCO couldn’t even show a positive y/y number, despite soaring CEO capex intensions (bottom panel)! Thus, we view this tech sub-group as a value trap rather than an opportunity and we think there are valid reasons why the market is currently valuing this index at a 20% discount to the broad market on a forward P/E basis to the broad market (third panel). Bottom Line: We reiterate our underweight stance in the S&P communications equipment index.  The ticker symbols for the stocks in this index are: BLBG: S5COMM – CSCO, JNPR, MSI, ANET, FFIV. ​​​​​​​

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles China's Decade Of Troubles China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary Global Investors Still Wary Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia Constraints On China's Tarrifs On Australia Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit US Tarrifs Reduce China In Trade Deficit US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage US Export Controls Amid Chip Shortage US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing China's Growth Potential Slowing China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China's Leaders Struggle With Debt China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Global Stock-To-Bond Ratio Rolled Over Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Chart 14Global Large Caps Catch A Bid Versus Small Caps Global Large Caps Catch A Bid Versus Small Caps Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK 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 – Province Of China Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: 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 selloff in crypto-currencies on May 19 may be overblown but the risk of government intervention is a rising headwind for this asset class. While environmental concerns are a threat to Bitcoin, the entire crypto-currency complex faces a looming confrontation over governance. Digital currencies are a natural evolution of money following coinage and paper. Moreover a sizable body of consumers is skeptical of governments and traditional banking. Loose monetary conditions are fueling a speculative mania. However, governments fought for centuries to gain a monopoly over money. As crypto-currencies become more popular, governments will step in to regulate and restrict them. Central bank digital currencies (CBDCs) threaten to remove the speed and transactional advantage of crypto-currencies, leaving privacy/anonymity as their main use-case. Feature The prefix “crypto” derives from the Greek kruptos or “hidden.” This etymology highlights one of the biggest problems confronting the crypto-currency craze in financial markets today. Speed and anonymity are the greatest assets of the digital tokens. But the former advantage is being eroded by competitors while the latter is becoming a political liability. In the 2020s, governments are growing stronger and more interventionist, not weaker and more laissez faire. Chart 1Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Bitcoin and rival crypto-currency Ethereum fell by 29.5% and 43.2% in intra-day trading on May 19, only to finish the day down by 13.8% and 27.2%, respectively. The market panicked on news that China’s central bank had banned firms from handling transactions in crypto-currencies. What really happened was that China’s National Internet Finance Association, China Banking Association, and Payment and Clearing Association issued a statement merely reiterating a 2013 and 2017 policy that already banned firms from handling transactions in crypto-currencies. These three institutions also warned about financial speculation regarding crypto-currencies.1 The crypto market suffered a spike in volatility because it is in the midst of a speculative mania. In the last five years, total market capitalization of crypto-currencies has risen from around $7 billion to $2.3 trillion,2 recording a 34,000% gain. Some crypto-currencies have even recorded returns in excess of that number over a shorter horizon. Price gains have been driven by retail buyers who may or may not know much about this new asset class (Chart 1). Prior to the May 19 selloff, prices had grown overextended and recent concerns over the environment, sustainability, and governance (ESG) had shaken confidence in Bitcoin and its peers. Chinese authorities have already banned financial firms from providing crypto services in a bid to deter ownership of crypto-currencies. And China is not alone. The latest market jitters are a warning sign that government interference in the crypto-currency market is a real threat. Regulation and sovereign-issued digital currencies are starting to enter the fray. While ultra-dovish central bank policies are not changing soon, and therefore crypto-currency price bubbles can continue to grow, crypto-currencies will remain subject to extreme volatility and precipitous crashes. In this report we argue that the fundamental problem with crypto-currencies is that they threaten the economic sovereignty of nation-states. Environmental degradation, financial instability, and black market crime, and other concerns about cryptos have varying degrees of merit. But they provide governments with ample motivation to pursue a much deeper interest in regulating a technological innovation that has the power to undermine state influence over the economy and society. Government scrutiny is a legitimate reason for crypto buyers to turn sellers. Does The World Need Crypto-Currencies? Broadly speaking, there are two primary justifications for crypto-currencies, centered on a transactional basis: speed and privacy/anonymity. The crux of crypto-currency creation rests on these two use cases.3 The speed of crypto-currencies comes from their ability to increase efficiency in local and global payment systems by facilitating financial transactions without the need of a third party (e.g. a financial institution). Cross-border settlement of traditional (fiat) currency transactions processed through the standard SWIFT communications system takes up to two business days. Most transactions involving crypto-currencies over a blockchain network are realized in less than an hour, cross-border or not.4 The fees involved with third-party payments are often more expensive than transacting with crypto-currencies. Simply put, excluding the “middleman” can save money. This is a selling point in a global market that expects to see retail cross-border transactions reach $3.5 trillion by the end of 2021, of which up to 5% are associated with transaction-based fees.5 But this breakthrough in payment system technology can be overstated and is not the main reason for using crypto-currency. Speculation drives current use, especially given that there is speculative behavior even among those who believe that cryptos are safe-haven assets or promising long-term investments (Chart 2). Chart 2Crypto-Currency Use Driven By Speculation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 3Consumers Growing Skeptical Of Banking Regulation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide If a person wants to buy an item from a company in a distant country, that person could use a crypto-currency just as he or she could use a credit card. Both parties would have a secure medium of exchange but, unlike with a credit card, both would avoid using fiat currencies. Neither party could conduct the same transaction using gold or silver. The crucial premise is the existence of an online community of individuals and firms who for one reason or another want to avoid fiat currencies. From a descriptive point of view, the crypto-currency phenomenon implies a lack of trust in modern governments, or at least their monetary systems, and an assertion of individual property rights. The list of crypto-currencies continues to grow. To date, there are approximately 9,800 of them. Some are trying to prove their economic value or use, while others have been created with no intended purpose or problem to solve. Even so, there has yet to be a crypto-currency that overwhelms the use of slower fiat money. In a recent Special Report, BCA Research’s Foreign Exchange Strategist Chester Ntonifor showed that crypto-currencies still have a long way to go to have a chance at replacing fiat monies. While crypto-currencies are showing signs of significant improvement as mediums of exchange, they still fall short as stores of value and units of account. The other primary case for crypto-currencies is privacy or anonymity. The bypassing of intermediaries implies a greater control of funds by the two parties of a transaction. Crypto-currencies are said to be more “private” compared to fiat money. Fiat money is controlled by governments and banks while crypto-currencies have only “owners.” Crypto-currencies are anonymous because they are stored in digital wallets with alphanumeric sequences – there is a limited personal data trail that follows crypto-currency compared to those of electronic fiat currency transactions. In a post-9/11, post-GFC, post-COVID world where a sizable body of consumers is growing more skeptical of government surveillance and regulation and banking industry practices (Chart 3), crypto-currencies give users more than just a means to transact with. However, privacy is not the same as security. Hacking and fraud can affect cryptos as well as other forms of money and attacks will increase with the value of the currencies. Bitcoin At The Helm Of Crypto-Currency Market Chart 4Bitcoin Slows Bitcoin Slows Bitcoin Slows Bitcoin has cemented its status as the number one currency in the crypto-verse.6 It is considered to be the first crypto-currency created, it is the most widely accepted, it is touted as a store of value or “digital gold,” and it is the most featured in quoting alternative crypto-currency pairs across crypto exchanges. As it stands, Bitcoin accounts for around 42% of total crypto-currency market capitalization.7 This share has declined from around 65% at the start of 2021 on the back of the frenzied rise of several alternative coins.8 But rising risks to Bitcoin’s standing will cause the entire crypto-market to retreat. In a Special Report penned in February, BCA Research’s Chief Global Strategist Peter Berezin argued that Bitcoin is more of a trend than a solution and that its usefulness is diminishing. Bitcoin’s transaction speed is slowing and its transaction cost is rising (Chart 4). Slowing speed and rising cost on the Bitcoin network are linked to a scalability problem. The crypto-currency’s network has a limited rate at which it can process transactions related to the fact that records (or “blocks”) in the Bitcoin blockchain are limited in size and frequency. This means that one of its fundamental justifications, transactional speed, will become less attractive over time, should the network not address these issues. Bitcoin also consumes a significant amount of energy, a controversy that is gaining traction in the crypto-currency market after Elon Musk, the “techno-king” of Tesla, cited environmental concerns in reversing his decision to accept Bitcoin payment for his company’s electric vehicles. Energy consumption rises as more coins are mined, since mining each new Bitcoin becomes more computer-power intensive. The need for computing power and energy will continue to increase until all 21 million Bitcoins (total supply) are mined, which is currently estimated to occur by the year 2140. Strikingly, the energy needed to mine Bitcoin over a year are comparable to a small country’s annual power consumption, such as Sweden or Argentina (Chart 5). Chart 5Bitcoin Consumes More Energy Than A Small Country … Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin also generates significant quantities of electronic waste (Chart 6). Chart 6… And Generates A Lot Of Electronic Waste Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin mining is heavily domiciled in China, which accounts for 65% of global mining activity (Figure 1). China’s energy mix is dominated by coal power, which makes up approximately 65% of the country’s total energy mix even after a decade of aggressive state-led efforts to reduce coal reliance. Of this, coal powered energy makes up approximately 60% of Bitcoin’s energy mix in China.9 With several countries aiming to minimize carbon emissions, and with approximately 60% of Bitcoin mining powered by coal-fired energy globally,10 Bitcoin imposes a major negative environmental impact. Figure 1Bitcoin Mining Well Anchored In Asia Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin does not shape up well when compared to gold’s energy intensity either. Bitcoin mining now consumes more energy than gold mining over a single year. While the energy difference is not large, the economic value is. Gold’s energy consumption to economic value trade-off is lower than that of Bitcoin. The production value of gold in 2020 was close to $200 billion, while Bitcoin was measured at less than $25 billion (Chart 7A). On a one-to-one basis, gold even has a lower carbon footprint than Bitcoin (Chart 7B). Chart 7AGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 7BGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Crypto-currency energy consumption and carbon footprint will attract the attention of government regulators. Of course, not all crypto-currencies are heavy polluters. But if the supply of cryptos is constrained by mining difficulties then they will require a lot of energy. If the supply is not constrained then the price will be low. Government Regulation Is Coming Environmental concerns point to the single greatest threat to crypto-currencies – the Leviathan, i.e. the state. In this sense the crypto market’s wild fluctuations on May 19, at the mere whiff of tougher Chinese regulation, are a sign of what is to come. Governments around the world have so far left crypto-currencies largely unregulated but this laissez-faire attitude is already changing. Environmental regulation has already been mentioned. Governments will also be eager to expand their regulatory powers to “protect” consumers, businesses, and banks from extreme volatility in crypto markets. But investors will underrate the regulatory threat if they focus on these issues. At the most basic level, governments around the world will not sit idly by and lose what could become significant control of their monetary systems. The ability to establish and control legal tender is a critical part of economic sovereignty. Governments won control of the printing press over centuries and will not cede that control lightly. If crypto-currencies are adopted widely, then finance ministries and central banks will lose their ability to manipulate the money supply and the general level of prices effectively. Politicians will lose the ability to stimulate the economy or keep inflation in check. Most importantly, while one may view such threats as overblown, it is governments, not other organizations, that will make the critical judgment on whether crypto-currencies threaten their sovereignty. Throughout the world, most crypto-currency exchanges are regulated to prevent money laundering. Crypto-currencies are not legal tender and, aside from Bitcoin, their use is mostly banned in China (Table 1). However, more specialized regulation that targets energy and economic use has yet to be brought into law across the world. Table 1World Governments Will Not Relinquish Hard-Fought Monopolies Over Money Supply Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In China, initial coin offerings (ICOs – the equivalent of an initial public offering on the stock market) and trading platforms are banned from engaging in exchanges between the yuan and crypto-currencies or tokens. In fact, China recognizes crypto-currencies only as virtual commodities or virtual property. India is another country where exchanges and ICOs are banned. While crypto-currencies are not banned, they are not legal tender. Indian policymakers have recently proposed banning crypto-currencies, however. The proposed legislation is one of the world’s strictest policies against crypto-currencies. It would criminalize possession, issuance, mining, trading, and transferring crypto-assets. If the ban becomes law, India would be the first major economy to make holding crypto-currency illegal. Even China, which has banned mining and trading, does not penalize possession. In the US, Secretary of the Treasury Janet Yellen has already expressed concerns regarding the illicit use of cryptos for supposed criminal gain.11 She is in alignment with European Central Bank President Christine Lagarde. Because of the anonymity of crypto-currencies, identifying users behind illicit transactions is difficult. This means regulators face headwinds in identifying transactions that are made for criminal gain, as compared to fiat transactions. Governments have long dealt with the anonymity of cash but they have ways of monitoring bank accounts and paper bills. Crypto-currencies are beyond their immediate sight of control and therefore will attract growing scrutiny and legislative action in this regard. The Colonial Pipeline ransomware attack on May 7, which temporarily shuttered about 45% of the fuel supply line for the eastern United States, illustrates the point. The DarkSide group of hackers who orchestrated the attack demanded a ransom payment of $4.4 million worth of Bitcoin, which Colonial Pipeline paid them on May 7. Shortly thereafter, unspecified “law enforcement agencies” clawed back the $4.4 million from the hackers’ account (transferring it to an unknown address) and DarkSide lost access to its payment server, DOS servers, and blog. This episode should not be underrated. It was a successful, large-scale cyber-attack on critical infrastructure in the world’s most powerful country. It highlighted the illicit uses to which crypto-currencies can be put. True, criminals demand ransoms in fiat money as well – and many crypto-currency operators will distance themselves from the criminal underworld. Nevertheless governments will give little slack to an emerging technology that presents big new law enforcement challenges and is not widely used by the general public. Ultimately governments will pursue their sovereign interests in controlling money, the economy, and trade, listening to their banking lobby, expanding their remit to “protect” consumers, and cracking down on illicit activity. Governments are not capable of abolishing crypto-currencies altogether, or the underlying technology of blockchain. But they will play a large and growing role in regulating them. Central Banks Advancing On Digital Currencies Central bank digital currencies (CBDCs) will leave crypto-currencies in the realm of speculative assets. CBDCs are a form of digital money denominated in a country’s national unit of account and represent a liability on a central bank’s balance sheet. This is different from current e-money that represents a claim on a private financial institution’s balance sheet. It is also different from crypto-currencies, because there is a central authority behind a CBDC, unlike with crypto-currencies due to their decentralized nature. In China, the People’s Bank of China (PBoC) has suggested its rollout of a digital yuan is “ready” despite no release to date. Beta testing is ongoing in several provinces. The PBoC’s justification for a digital yuan comes from China’s growing cashless economy. The transition away from cash is largely thanks to mobile payment platforms like Alibaba’s Alipay and Tencent’s WeChat Pay, which, between the two of them, control almost the entire mobile payments market of some 850 million users. There is a significant amount of systemic risk in this system – one reason why Chinese authorities have recently subjected these companies to new scrutiny and regulation. Should Alibaba or Tencent go bankrupt, the local payment system will crash. The PBoC’s efforts will increase competition in the local payments space and reduce this systemic risk. Policymakers are also concerned that as Chinese citizens choose to hold their money in digital wallets provided by Alibaba and Tencent instead of bank accounts, liquidity is being drained from the traditional banking system, putting deposit levels at banks under strain, and posing risks to liability matching. The digital yuan will still involve a third party, unlike crypto-currencies which do not. Doing away with commercial banks is not a reality – indeed the Chinese Communist Party seeks to buttress the state-owned commercial banks in order to maintain control of the economy. What the digital yuan does, and other CBDCs will do too, is utilize blockchain technology, which is faster and more secure than traditional payment networks. In the US, the Fed has been studying the viability of a CBDC US dollar. The Fed has stated that it is carefully exploring whether a CBDC will lead to “safer, less expensive, faster, or otherwise more efficient payments.” While the Fed has yet to find a single standout case for a CBDC US Dollar, Fed Chair Jerome Powell said last year that the US has a “competitive payments market” with “fast and cheap services, particularly in comparison to other nations exploring a CBDC.” To date, the Fed’s observation is that many of the challenges that CBDCs hope to address do not apply to the US, including disuse of physical cash, narrow reach or high concentration of banking, and weak infrastructure for payment systems. Rather, the Fed is more focused on developing the FedNow real-time payment system for private banks. This is much the same as in Europe, where physical cash still plays a major role in day-to-day economic activity and where local payment systems are fast and secure. But central banks around the world continue to engage in work centered around CBDCs (Charts 8A and 8B) – and China’s progress will encourage others to move faster. Advanced economies are mostly interested in creating a safer and more efficient payment system, while emerging and developed economies have interest across several areas such as financial stability, monetary policy setting, and inclusiveness of banking, as well as efficiency and safety (Chart 9). CBDCs are especially attractive to emerging market policy makers at targeting those who lack access to traditional banking. Chart 8ACentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 8BCentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 9Central Banks CBDC Interest Areas Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In remote areas, access to banking is scarce and expensive. CBDCs can help solve this problem. Individuals would have CBDC accounts directly on a central bank ledger. They could then access their money and transact through a digital wallet application that is linked to the CBDC account. Giving people access to digital currency would allow them to transact quickly, in remote settings, without the need of hard currency. Monetary policy transmission is also better in advanced economies. In emerging markets, there are bottlenecks in local financial markets. Looser central monetary policy does not always translate into cheaper financing across the economy. In remote and poverty stricken areas, monetary policy transmission is sticky, meaning high costs of borrowing can persist even through accommodative policy cycles. This is a smaller issue in advanced economies. Payment systems in advanced economies are due an overhaul in security and efficiency, and CBDCs and blockchain technology will provide this. CBDCs will prove to be just as efficient to transact with as any crypto-currencies available today. CBDCs will also be legal tender and accepted by all vendors. The anonymity factor will be lost but this will not be a problem for most users (whereas legal issues will become a problem for crypto-currencies). The probability of central banks issuing CBDCs in both the short and medium term, both in the retail and wholesale space, is rising. If advanced economies like those of the G7 issue CBDCs soon, policy makers will undoubtedly ensure the use of it over the currently circulating and partially accepted crypto-currencies. The endgame will leave crypto-currencies in the highly speculative asset class, perhaps even in the black market where anonymity is valued for transactions that wish not to be tracked. Investment Takeaways Prices of crypto-currencies may continue to rise given sky-high fiat money creation amid the COVID pandemic and ultra-low interest rates. Digitalization is the natural next step in the evolution of money from precious metals to paper banknotes to electronic coin. But the market leader, Bitcoin, is encountering more headwinds. The primary case for the use of Bitcoin is challenged due to slowing transaction speeds and rising transaction costs. The virtual currency is primarily mined using coal-powered energy, resulting in growing scrutiny from governments and consumers. Government regulation is entering the ring and policymakers will take an increasingly heavy-handed role in trying to ensure that cryptos do not undermine economic sovereignty, financial stability, and law and order. When central banks begin to rollout digital currencies, especially those domiciled in advanced economies, crypto-currencies as medium of exchange will lose much of their allure. Crypto-currencies will remain as anti-fiat currencies and speculative assets. Risks To The View Given the controversy surrounding crypto-currencies, it is only fair to state outright the risks to our view. We would also recommend clients read our colleague Dhaval Joshi’s latest bullish take on Bitcoin. First, scaling up Bitcoin’s network and processing transactions in batches instead of single transactions will resolve transaction time and cost risks, restoring efficiency. This is a clear solution to efficiency concerns. However, scaling and batching transactions are not on the immediate horizon of Bitcoin developers. Bitcoin’s network will still need to undergo another “halving” in order for this risk to subside and for the network to scale. A halving of the network will only occur again in 2024.12 Second, on the environment: Bitcoin mining is not solely dependent on fossil fuel energy that gives it a “dirty” footprint. Renewables already make up some 25% of Bitcoin mining. Increasing the use of renewables in Bitcoin’s energy mix will help lower its environmental impact. However, this is easier said than done. Global renewable energy has yet to scale up to a point where it can consistently out-supply existing fossil-fuel energy. Mining hardware also has its associated carbon footprint that would need to be addressed. And location matters too. Crypto-currency mining farms are large-scale projects. Simply uprooting operations to a country that could lower the carbon footprint of a mining farm or two is not viable due to the costs involved. Hence crypto-currency mining will probably continue to be a “dirty” operation but a rapid shift to renewables would challenge our thesis. Bitcoin’s network is also based off a “proof of work” protocol. Miners must prove that a certain amount of computational effort has been expended for confirming blocks on the network, allowing transactions to be processed. Proof of work is energy intensive. Other crypto-currencies, like Ethereum, will adopt a “proof of stake” protocol. Simply put, transactions are confirmed by users and their stake in the associated crypto-currency. Proof of stake is less energy intensive compared to proof of work. Third, as to government regulation, the longer policymakers take to enact legislation targeting crypto-currencies, the larger their market will grow. Regulation in China and India may set a benchmark for major economies but not all will follow in the Asian giants’ footsteps. Some governments have been slow to study crypto-currencies, meaning legislation aimed at governing or regulating them may still be long in coming. Innovation is a good thing and free economies will not wish to restrain crypto-currencies or blockchain technology unduly, for fear of missing out. Fourth, on CBDCs, some central banks may only adopt them based on their respective economic needs. However, rising crypto-currency populism drives associated economic risks which can force the hands of central banks to adopt CBDCs in lieu of said needs. Each country faces unique challenges. Some central banks may not want to be left behind even if they believe their policy framework is facilitating economic activity efficiently. While the Fed has stated that it will not adopt a CBDC for the primary reason of ensuring payment security since it believes it already has a safe system in place, this view will change. The Fed could justify a move to a CBDC US dollar on the single basis of transitioning to a more sophisticated technology for the future. The Fed will not want to be caught behind the curve considering the PBoC is priming its digital yuan for release soon. Technological leadership is a strategic imperative of the United States and that imperative applies to financial technology as well as other areas.   Guy Russell Research Analyst GuyR@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Muyao Shen, “China Reiterates Crypto Bans From 2013 and 2017”, coindesk, May 18, 2021, coindesk.com. 2 As of May 11, 2021. 3 There are several other reasons or “problems” that crypto-currencies are created for or to solve, but speed and privacy form the basis of crypto-currencies first coming into existence. 4 Not all crypto-currencies transact in less than an hour. But there are many that transact in several minutes and in some cases, mere seconds. As the leading crypto-currency, Bitcoin takes approximately one hour for a transaction to be fully verified over its network. 5 “McKinsey’s Global Banking Annual Review”, McKinsey, Dec. 9, 2020, mckinsey.com. 6 We use Bitcoin as an example to understand the risk and impact of forthcoming government regulation and competition. Because of Bitcoin’s status, any significant risks that threaten the crypto-currency’s standing as the number one currency will threaten the entire market. 7 As of May 20, 2021. Figure varies daily. See www.coinmarketcap.com for more information. 8 Alternative currencies such as Ethereum, Ripple, Binance Coin, Dogecoin, and Cardano have chipped away at Bitcoin’s crypto-market dominance through 2021. 9 According to The Center For Alternative Finance, The University Of Cambridge. 10 According to The Center For Alternative Finance, The University Of Cambridge. 11 Data on the use of crypto-currencies for illicit activitiessays otherwise. Of all crypto-currency transactions, it is estimated that only 2.1% are used for illicit activities. See “2021 Crypto Crime Report”, Chainalysis, chainalysis.com. 12 A Bitcoin halving is when the reward for mining Bitcoin transactions is cut in half. This event also cuts Bitcoin's inflation rate and the rate at which new Bitcoins enter circulation, in half. Bitcoin last halved on May 11, 2020.

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

Tech titans (AAPL, MSFT, AMZN, GOOGL & FB) peaked last September at roughly 26% market cap weight in the SPX, and have since fallen 300bps despite four of the five stocks recently hitting new all-time highs (AAPL is the last man standing). This portfolio rebalancing that we first recommended in early September away from tech stocks and into other deep cyclicals remains intact, and while recently the tech titans have stabilized, more pain likely looms. The chart shows that the S&P 5 have been perfectly inversely correlated with the 10-year US Treasury (UST) yield. Keep in mind that bonds typically lead stocks: last early-August the 10-year UST yield troughed near 50bps and a month later the tech titans peaked (top panel). The implication is that when the selloff in the bond market resumes it will serve as a catalyst for a catch down phase in the tech titans. Bottom Line: We remain cyclically neutral the S&P tech sector, underweight the S&P communications services sector and continue to recommend investors rebalance away from the tech titans and into the still undervalued S&P industrials and S&P energy sectors. Also, from a structural perspective, we reiterate our long SPY/short QQQ trade. Chart 1 Are Tech Titans In Trouble? Are Tech Titans In Trouble?