Trade / BOP

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 2Reconciliation Bill Also Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 3Biden Cannot Spare A Single Vote In Senate China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 13Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

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

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Chart 4South Asia Is Characterized By Very Low Per Capita Incomes South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.

Dear client, In lieu of our weekly bulletin next Friday, I will be hosting a webcast on Tuesday, June 29 to discuss the latest trends in FX markets, given the hawkish shift by the Federal Reserve. I hope to answer your questions during this webcast. Kind regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights The hawkish shift by the Federal Reserve last week jolted the dollar higher, but our bias is that the rally will be quite short-lived. The primary reason is that US real rates will remain depressed, relative to the rest of the world, for the foreseeable future. The US balance of payments backdrop continues to deteriorate suggesting that the willingness by foreign concerns to fund the trade deficit will be a drag on the dollar. Global trade is staging a recovery. Historically, this has been synonymous with stronger global growth and a weaker dollar. Most countries are seeing foreign direct investment (FDI) inflows accelerate in the first few months of 2021, on the back of potential profitable investment projects. This is set to continue. The advantage appears to be particularly pronounced in commodity-producing countries that are witnessing a strong terms-of-trade tailwind. Feature Chart I-1The Dollar Rallied Hard On The Fed Shift On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments Last week, the Federal Reserve surprised markets with a hawkish shift. First, the median dots suggested at least two rate hikes by the end of 2023, a shift from the March communiqué where no rate hikes were expected until 2024. Second, the Fed revised its inflation forecast for 2021, from 2.4% to 3.4%, while suggesting that this should still be transitory. Longer-term inflation expectations were left largely unchanged. Finally, the discussion around tapering was acknowledged, which was interpreted as a sign that the Fed was inching closer to withdrawing monetary stimulus. The reaction in the FX market was violent. From a low of 90.5 last week, the DXY index rallied 2% and currently sits at 91.8. The most hit currencies were procyclical, even where central bankers have been more hawkish than the Fed, such as Norway and New Zealand (Chart I-1). Our initial take was that the market moves were a knee-jerk reaction, likely to be sustained in the coming weeks and months but would prove fleeting. As we finally digest the implications of the Federal Reserve’s shift, it is difficult to make the case for a sustainable rally in the US dollar. The jump in the dollar coincided with an upward revision in market expectations for rate hikes in 2022 and 2023. Markets now expect the Fed to lift interest rates by 34 bps in 2022 and an additional 51 bps in 2023. Notably, this is higher than what the market expected at the start of the year (Chart I-2, top panel). On the surface, this explains the dollar rally. But market interest rate expectations between the US and the rest of the world were largely unchanged, as real rates moved higher almost everywhere within the G10 (Chart I-2, bottom panel). From this perspective, the dollar rally was largely an overreaction. Higher inflation in the US, especially compared to the rest of the world, has usually been a bearish development for the dollar. The simple reason is that the fair value of the currency incrementally declines on a purchasing power parity basis. Therefore, the Federal Reserve’s adjustment higher of US inflation should not have reinvigorated bulls, unless they believe the Fed will actively move ahead of the inflation curve (Chart I-3). We did not get such a reading from last week’s release. And given that the US is generating the fastest inflation in the G10 and has the sole central bank targeting an inflation overshoot, our bias is that real rates will remain depressed for the foreseeable future Chart I-2Long-Term Rates Did Not Shift In Favor Of The Dollar Long-Term Rates Did Not Shift In Favor Of The Dollar Long-Term Rates Did Not Shift In Favor Of The Dollar Chart I-3Higher Inflation In The US Is Negative For The Greenback Higher Inflation In The US Is Negative For The Greenback Higher Inflation In The US Is Negative For The Greenback The Fed suggested that discussions have begun around tapering, but again, this was little reason for a rally in the dollar. Market participants had already expected tapering to begin sometime next year (Table I-1A and I-1B). Meanwhile, the Fed reiterated that any tapering discussions will be communicated well in advance. It is also worth noting that the Fed is lagging other central banks in tapering asset purchases, notably the Bank of Canada. Table 1AMarket Participants Already Expect The Fed To Taper Next Year On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments Table I-1BMarket Participants Already Expect The Fed To Taper Next Year On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments The above analysis suggests that the Fed provided an excuse for an oversold dollar to bounce higher, rather than trigger a sea change in the currency outlook. So, from a tactical perspective, the rally could continue, pushing us towards 94 on the DXY. However, longer term, the underlying drivers of the dollar suggest a bearish view remains appropriate. This week’s report focuses on one such longer-term driver – the balance of payments. The US trade deficit continues to widen at an accelerating pace, while improving in many other countries. From this perspective, the willingness by foreign concerns to fund the trade deficit will continue to be a drag on the dollar. Global Trade And The Dollar In Q1 2021, global trade was higher than pre-crisis levels, rising 10% year-on-year. According to the United Nations Conference on Trade and Development (UNCTAD), the strong rebound continues to be driven by the strong exports from East Asian economies. These trends are expected to continue in the near-term, especially once trade in services can resume in earnest on the back of vaccination progress. Chart I-4US Balance Of Payments Are Negative For The Dollar On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments Global FDI inflows should also begin to rebound going into next year, following a tumultuous decline in 2020. According to UNCTAD, global FDI inflows plunged by 35%, bringing total FDI inflows to below US$1 trillion. As reinvested earnings make up a huge share of total FDI, the earnings decline last year curtailed flows. Looking ahead, UNCTAD expects FDI flows to recover fully in 2022, under their optimistic scenario. Over the much longer term, the headwinds to trade and FDI flows remain, including rising protectionism, global onshoring of production and geopolitical tensions. De-globalization is here to stay, as policymakers promote more regulation and intervention in key industries. That said, over the next few years, balance of payments dynamics will remain important and could be the key driver for currencies, as investors become more discerning between countries and sectors with a high return on capital and those without. In this report, we look at the balance-of-payment dynamics in the G10. Specifically, the basic balance, which takes the sum of the current account and net long-term capital inflows (and therefore tends to measure the underlying competitiveness of a currency more accurately). On this basis, Sweden, the euro area, Australia and Norway sport the best surpluses, while the US is the worst (Chart I-4). United States Chart I-5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US basic balance is deteriorating at an accelerating pace (Chart I-5). Just this week, the current account balance for Q1 came in at -$195.7 billion, the widest in over a decade. This is also occurring at a time when FDI inflows are deteriorating. If this trend continues, it could continue to undermine the US currency. The basic balance is approaching -4% of GDP. This has reversed most of the improvement in the basic balance since the Global Financial Crisis. This confirms our bias that the dollar likely put in a major top last year and has entered a multi-year decline. On portfolio flows, the most recent TIC data show that US Treasurys were aggressively bought in March and April by foreigners. Equity inflows also remain strong. However, should US real rates remain deeply negative, this will curtail foreign appetite for US government bonds, and require an adjustment lower in the dollar.           Euro Area Chart I-6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The euro area maintains a structural current account surplus, which has been improving in recent quarters (Chart I-6). Since the beginning of the year, the surplus has increased from €5.8 billion to €31.4 billion in April. Meanwhile, after about two decades of underinvestment in the euro area, FDI inflows are now at the strongest level, to the tune of about 2% of GDP. This is nudging the euro area’s basic balance to a record 4% of GDP. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. This is likely to persist, as strong FDI inflows, especially in the green energy sector, continue. Portfolio investment has turned strongly negative in recent quarters, but this is likely a crowding out of bond investors by strong purchases from the ECB. Meanwhile, the euro area generates a surplus of savings that need to be reinvested abroad.             Japan Chart I-7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Ever since the Fukushima crisis, the Japanese trade balance has been severely hampered by rising energy imports. The key pillar for the basic balance surplus is income receipts from Japan’s large investment positions abroad. This should continue to keep the basic balance in surplus, albeit at lower levels than a decade ago (Chart I-7). Going forward, the Japanese trade balance should keep improving as exports maintain their strong growth. On the service side of the equation, foreign visitors should also increase, especially as the Olympics move ahead. At their peak, foreign visitors were about 2% of the Japanese population, compared to almost nil today. The improvement in the goods and services balance should nudge the basic balance above 2% of GDP in the coming quarters. Net portfolio investments are accelerating, especially given the recent underperformance of Japanese equities (making them cheap), and positive real rates from longer-term Japanese corporate and government bonds.         United Kingdom Chart I-8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The UK trade and current account balance is deteriorating again, on the back of a more tumultuous post-Brexit transition. This has nudged the basic balance into negative territory (Chart I-8). The strong rally in the pound has also chiselled away some of the competitive edge British goods commanded on a global landscape. Significant foreign direct investment will be necessary to prevent the pound from adjusting much lower. There is progress, as the Conservative government has signed some significant trade deals over the course of the year. This should assuage foreign investor concerns over the potential for market access, should they invest in UK production. Portfolio investment in the UK has rolled over, but this is likely to be temporary if global equity markets remain resilient. Real rates are also improving in the UK, which should stem bond outflows. The key for the pound in the coming years will be productivity improvements which will allow foreign investors to keep financing the trade deficit.         Canada Chart I-9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments The Canadian basic balance has modestly improved, after being flat for over a decade. The improvement has been in the current account and is specifically driven by income receipts from Canada’s improving net international investment position (Chart I-9). Foreign direct investment has also remained resilient, and should remain so, given strong commodity prices. Canada is one of the largest exporters of crude oil, meaning the increase in petroleum prices will buffet the trade balance. In fact, since the 2020 lows, the monthly trade balance has recovered from almost negative C$6 billion to C$0.6 billion in April. Today, the basic balance stands at a surplus of 1% of GDP and should continue to improve.                   Australia Chart I-10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia sports the best improvement in both its trade and current account balance over the last few years. This has pushed the basic balance near a record 3.75% of GDP (Chart I-10). Australia’s long affair with a current account deficit is over. Investment in projects in the resource space are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. Australia’s comparative advantage in exports of LNG will likely be the next key driver of the trade balance, replacing coal shipments. This is consistent with the ESG megatrend. Net portfolio investment has been falling for years, but this just reflects Australia’s rising savings. In other words, the current account surplus is being recycled abroad. In short, the Aussie dollar has a large amount of running room, albeit, barring a tactical correction.             New Zealand Chart I-11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments The New Zealand basic balance has been negative for many years, only recently going into balance (Chart I-11). The boom in agricultural prices has helped boost the trade balance into surplus, but this has not been sufficient to bring the current account into balance. Coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities have keep the current account in structural deficit. Portfolio investments are accelerating out of New Zealand. The last time they hit -8% of GDP was just after the financial crisis. It is not clear why foreign investors are shunning this rather defensive market, but high valuations may be playing a key role. Importantly, FDI inflows remain steady, near 1.75% of GDP. Going forward, New Zealand should continue to see modest improvement in its basic balance, especially relative to the US, supporting the kiwi.           Switzerland Chart I-12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland has had a structural uptrend in its trade balance for decades (Chart I-12). This has buffeted both the current account and the basic balance. It has also allowed the trade-weighted Swiss franc to outperform on a structural basis. In Q1, the current account surplus rose to CHF 16 billion, a 60% increase from Q1 2020, driven by an improvement in the goods trade balance. However, both primary and secondary income were a drag on the current account balance. The net international investment position also improved on the back of a net increase in foreign asset purchases. However, a strong dollar in Q1 reduced the net value of foreign currencies in the portfolio. The positive balance-of-payment backdrop continues to create a headache for the Swiss National Bank. CHF has been weak this year, and the SNB will likely continue to intervene in the foreign exchange markets to calm future appreciation in the franc. That said, we expect the trade-weighted franc to rise on a structural basis.          Norway Chart I-13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Norway’s trade balance was heavily hit by the COVID-19 crisis but is slowly recovering (Chart I-13). The trade surplus started to plunge sharply due to falling energy prices at the beginning of the lockdown. Going forward, the reopening of the global economy, especially Europe, will benefit Norwegian exports of oil and gas. Meanwhile, tepid investment in global oil and gas extraction over the past five years will ensure Norway’s terms of trade remains robust. This will especially be the case thanks to growing production from the new Johan Sverdrup field. From a more fundamental perspective, the krone will also benefit from positive income flows. Norway has one of the biggest NIIPs in the world, which generates large income receipts that skew heavily toward equity dividends. This characteristic strengthens the bond between the NOK and global equities, making it the perfect procyclical currency. On a structural basis, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome.   Sweden Chart I-14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish current account balance has improved smartly in the last few quarters, boosting the basic balance to a surplus of over 5% of GDP. While the trade surplus has certainly improved, the primary income surplus has been the key driver (Chart I-14). FDI inflows have not had a strong impact on the basic balance. In terms of portfolio investment, this has turned negative as Riksbank purchases have crowded out investors. Income receipts have also needed to be recycled. In conclusion, the Swedish krona remains one of our favorite currencies due to its increasing basic balance surplus and its cheap valuation. We were stopped out of our long Nordic basket trade (NOK and SEK) against both the euro and the US dollar but will be looking to re-establish at more attractive levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 3China Catching Up To Cuba On Basic Wellbeing China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 4China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 5BChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues China's Rise Continues China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Highlights Oil demand expectations remain high. Realized demand continues to disappoint. This means OPEC 2.0's production-management strategy – i.e., keeping the level of supply below demand – will continue to dictate oil-price levels. US producers will remain focused on consolidation via M&A and on returning capital to shareholders, in line with the Kingdom of Saudi Arabia's (KSA) expectation. Going forward, shale producers will focus on protecting and growing profit margins. The durability of OPEC 2.0's tactical advantage arising from its enormous spare capacity – ~ 7mm b/d – is difficult to gauge: Tightening global oil markets now in anticipation of Iran's return as a bona fide exporter benefits producers globally, and could accelerate the return of US shales if that return is delayed or re-opening boosts demand more than expected. We are raising our average Brent forecast for 2021 to $66.50 vs. $63/bbl earlier, with 2H21 prices averaging $70/bbl. We are moving our 2022 and 2023 forecasts up slightly to $74 and $81/bbl (Chart of the Week). WTI will trade $2-$3/bbl lower. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to further steepen backwardations in forward curves. Feature While the forecasted rebound in global oil demand continues to drive expectations for higher prices, it is the production discipline of OPEC 2.0 and capital discipline imposed on US shale producers that has and will continue to super-charge the recovery of prices. Continued monetary accommodation and fiscal stimulus notwithstanding, realized global oil demand has mostly flatlined at ~ 96mm b/d following its surge in February, as uncertainty over COVID-19 containment keeps governments hesitant about reopening their economies too quickly. Stronger demand in Asia, led by China, has been offset by weaker demand in India and Japan, where COVID-19 remains a deterrent to re-opening and recovery. The recovery in DM demand generally stalled over this period even as vaccine availability increased (Chart 2). Chart of the WeekOPEC 2.0 Comfortable With Higher Prices Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 2Global Demand Recovery Stalled Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices That likely will change in 2H21, but it is not a given: The UK, which has been among the world leaders in COVID-19 containment and vaccinations, delayed its full reopening by a month – to July 19 – in an effort to gain more time to bolster its efforts against the Delta variant first identified in India. In the US, New York state lifted all COVID-19-induced restrictions and fully re-opened this week. Still, even in the US, unintended inventory accumulation in the gasoline market – just as the summer driving season should be kicking into high gear – suggests consumers remain cautious (Chart 3). Chart 3Unintended Inventory Accumulation in US Gasoline Market Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices We continue to expect the re-opening of the US and Europe (including the UK) will boost DM demand in 2H21, and wider vaccine availability will boost EM oil demand later in the year and in 2022. For all of 2021, we have lifted our demand-growth estimate slightly to 5.3mm b/d from 5.2mm b/d last month. We expect global demand to grow 4.1mm b/d next year and 1.6mm b/d in 2023. Our 2021 estimates are in line with those of the US EIA and the IEA. OPEC is more bullish on demand recovery this year, expecting growth of 6mm b/d. We continue to believe the risk on the demand side remains to the upside; however, given continued uncertainty around global COVID-19 containment, we remain circumspect. Supply-Side Discipline Drives Oil Prices OPEC 2.0 remains committed to its production-management strategy that is keeping the level of supply below demand. Compliance with production cuts in May reportedly was at 115%, following a 114% rate in April.1 Core OPEC 2.0 – i.e., states with the capacity to increase production – is holding ~ 7mm b/d of spare capacity, according to the IEA, which will allow it to continue to perform its role as the dominant supplier in our modeling (Chart 4). Earlier this year, KSA's Energy Minister Abdulaziz bin Salman correctly recognized the turn in the market that likely ensures OPEC 2.0's dominance for the foreseeable future – i.e., the shift in focus of the US shale-oil producers from production for the sake of production to profitability.2 This is a trend that has been apparent for years as capital markets all but abandoned US shale-oil producers. Chart 4OPEC 2.0 Remains Dominant Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Producers outside OPEC 2.0 – what we refer to as the "price-taking cohort" – have prioritized shareholder interests as a result of this market pressure, and remain focused on sometimes-forced consolidation via M&A, which we have been expecting.3 The significance of this evolution of shale-oil production is difficult to overstate, particularly as the survivors of this consolidation will be firms with strong balance sheets and a focus on profitability, as is the case with any well-run manufacturing firm. We also expect large producers to opportunistically shed production assets to reduce their carbon footprints, so as to come into compliance with court-ordered emission reductions and shareholder demands to reduce pollution.4 With the oil majors like Shell, Equinor and Oxy divesting themselves of shale properties, production increasingly will be in the hands of firms driven by profitability.5 We expect US shale-oil production to end the year at 9.86mm b/d and to average 9.57mm b/d next year; however, as the shales become the marginal global supply, production could become more volatile (Chart 5). The consolidation of US production also will alter the profitability of firms continuing to operate in the shales. We expect breakeven costs to fall as acquired production by stronger firms results in high-grading of assets – only the most profitable will be produced given market-pricing dynamics – while less profitable acreage will be mothballed until prices support development(Chart 6). Chart 5US Producers Focus On Profitability Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 6Shale Breakevens Likely Fall As Consolidation Picks Up Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Supply-Demand Balances Tightening The current round of M&A consolidation and OPEC 2.0's continued discipline lead us to expect continued tightening of global oil supply-demand balances this year and next (Chart 7). This will allow inventories to continue to draw, which will keep forward oil curves backwardated (Chart 8). Chart 7Supply-Demand Balances Will Continue To Tighten Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 8Tighter Markets, Lower Stocks Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices The critical factor here will be OPEC 2.0's continued calibration of supply in line with realized demand and the return of Iran as a bona fide exporter, which we expect later this year. OPEC 2.0's restoration of ~ 2mm b/d of supply will be done by the beginning of 3Q21, when we expect Iran to begin restoring production and visible exports (i.e., in addition to its under-the-radar sales presently). The return of Iranian supply – and a possible increase in Libyan output – will present some timing difficulties for OPEC 2.0's overall strategy, but they will be short-lived. We continue to monitor output to assess the evolution of balances (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Investment Implications Oil demand will increase over the course of 2H21, as vaccines become more widely distributed globally, and the massive fiscal and monetary stimulus deployed worldwide kicks economic activity into high gear. On the supply side, markets will tighten on the back of continued restraint until Iranian barrels return to the market. The balance of risk is to the upside, particularly if the US and Iran are unable to agree terms that restore Iran as a bona fide exporter. In that case, the market tightening now under way will result in sharply higher prices. That said, realized demand growth has stalled over the past three months, which can be seen in unintended inventory accumulation in the US gasoline markets just as the summer driving season opens. We are raising our average Brent forecast for 2021 to $66.50 vs. $63/bbl earlier, with 2H21 prices averaging $70/bbl. We are moving our 2022 and 2023 forecasts up slightly as well to $74 and $81/bbl (Chart of the Week). WTI will trade $2-$3/bbl lower. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to further steepen backwardations in forward curves. The big risk, as highlighted above, remains an acceleration of COVID-19 infections, hospitalizations and deaths, which force governments to delay re-opening or impose localized lockdowns once again. In this regard, KSA's strategy of calibrating its output to realized – vice forecasted – demand likely will remain in place.   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 China's refinery throughput surged 4.4% to 14.3mm b/d in May, a record high that surpassed November 2020's previous record of 14.26mm b/d, according to S&P Platts Global. The increased runs were not unexpected, and were largely accounted for by state-owned refiners, which operated at 80% of capacity after coming out of turnaround season. Turnarounds will fully end in July. In addition, taxes on niche refined-product imports are due to increase, which will bolster refinery margins as inventories are worked down. China's domestic crude oil production was just slightly more than 4mm b/d. Base Metals: Bullish China's Standing Committee approved the release an undisclosed amount of its copper, aluminum and zinc stockpiles via an auction process in the near future, according to reuters.com. The government disclosed its intent on the website of National Food and Strategic Reserves Administration on Wednesday; however, specifics of the auction – volumes and auction schedule, in particular – were not disclosed. Prices had fallen ~ 9% from recent record highs in the lead-up to the announcement, which we flagged last month.6 Prices rallied from lows close to $4.34/lb on the COMEX Wednesday (Chart 9). Precious Metals: Bullish After a worse-than-expected US employment report, we do not expect the Federal Reserve to lift nominal interest rates in Wednesday’s Federal Open Market Committee (FOMC) meeting. The Fed will only raise rates once the US economy reaches a level consistent with its definition of "maximum employment." Wednesday’s interest rate decision will be crucial to gold prices. If the Fed does not mention asset tapering or an interest-rate hike, citing current inflation as a transitory phenomenon, gold demand and prices will rise. On the other hand, if the Fed indicates an interest rate hike sooner than the previously stated 2024, this will weigh on gold prices (Chart 10). Ags/Softs: Neutral As of June 13, 96% of the US corn crop had emerged vs. the five-year average of 91%, according to the USDA. 68% of the crop was rated in good to excellent condition, slightly below the five-year average. In the bean market, 94% of the crop was planted as of 13 June, vs. the five-year average of 88%. The Department reported 86% of the crop had emerged vs. the five-year average of 74%. According to the USDA, 52% of the bean crop was in good-to-excellent condition vs the five-year average of 72%. Chart 9 Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 10 Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices   Footnotes 1     Please see OPEC+ complies with 115% of agreed oil curbs in May - source published by reuters.com on June 11, 2021. 2     Please see Saudis raise U.S. and Asian crude prices for April delivery published by worldoil.com on March 8, 2021. 3    Please see US shale consolidation continues as Independence scoops up Contango Oil & Gas published by S&P Global Platts on June 8, 2021. 4    We discuss this in A Perfect Energy Storm On The Way, published on June 3, 2021.  Climate activism will become increasingly important to the evolution of oil and natural gas production, and likely will lead to greater concentration of supply in the hands of OPEC 2.0 and privately held producers that do not answer to shareholders. 5    Please see Interest in Shell's Permian assets seen as a bellwether for shale demand published by reuters.com on June 15, 2021. 6    Please see Less Metal, More Jawboning, which we published on May 27, 2021.  It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss the outlook for China’s economy and financial markets, a year into policy normalization. The webcasts will be held on Tuesday, June 22 at 10:00 am EDT (English), and Thursday, June 24 at 9:00 am HKT (Mandarin). We will return to our regular publishing schedule on Wednesday, June 30. Best regards, Jing Sima, China Strategist   Feature China’s onshore stocks rebounded in the past two months on the back of a rapidly appreciating RMB versus the US dollar and accelerating foreign capital inflows (Chart 1). However, in our view, China’s domestic policy backdrop and economic fundamentals do not support a sustained rally in Chinese stocks in the next six months. The RMB’s rise vis-à-vis the US dollar will likely falter in the second half of the year as China’s growth weakens. A narrowing in real yields later this year between China’s government bonds and US Treasuries will also discourage foreign flows into Chinese assets. Performance of Chinese cyclical stocks versus defensives failed to decisively breakout in both the onshore and offshore equity markets. An underperformance in cyclical stocks relative to defensives has historically pointed to waning market sentiment towards the Chinese economy (Chart 2). Chart 1Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Chart 2Cyclical Stocks Continued To Underperform Defensives Cyclical Stocks Continued To Underperform Defensives Cyclical Stocks Continued To Underperform Defensives The number of onshore stocks with prices rising versus falling remains low, even though there has been a slight improvement this year from Q4 2020. The narrow breath in the equity market implies that recent rebound in A-share stocks has been largely driven by a handful of companies (Chart 3). Such narrow breadth suggests that the rebound in Chinese stock prices will not sustain (Chart 4). Chart 3A Narrow-Based Market Rally in A-Shares A Narrow-Based Market Rally in A-Shares A Narrow-Based Market Rally in A-Shares Chart 4Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks A tightened monetary and credit environment has created obstacles for Chinese equities since early this year. Credit numbers released last week show that credit growth deceleration has gathered speed in May, raising the risk of policy overtightening, i.e. credit growth undershooting the government’s 2021 targets. We could see some moderation in the credit growth deceleration into 2H21. A delay in the rollout of local government (LG) bonds and LG special purpose bonds (SPBs) in the first five months of the year means the pace of LG bond issuance between June and October will escalate, which will help to stabilize credit growth. However, weak corporate bond net financing and contracting shadow banking will cap the upside in credit expansion. Chart 5The Economy Could Surprise The Market To The Downside In Q3 The Economy Could Surprise The Market To The Downside In Q3 The Economy Could Surprise The Market To The Downside In Q3 Additionally, if more LG bonds come onto the market in Q3, then we could see tighter interbank liquidity conditions and higher bond yields. This, in turn, would partially offset the positive effects on the economy and equity market from a slower pace in credit growth deceleration. For the next six months, we continue to hold an underweight position in Chinese onshore and investable stocks, in both absolute terms and within a global equity portfolio. Policy tightening has not reversed course and there is an escalating risk that economic data will surprise the market to the downside in Q3 (Chart 5). Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com     Macro Policy Conditions Are Still Unfavorable For Risk Assets A further deterioration in the credit impulse in May reflects Chinese authorities’ efforts to reduce local government leverage and shadow banking activities. Net corporate bond financing contracted for the first time since early 2018, driven by shrinking local government financing vehicle (LGFV) bonds (Chart 6). Meanwhile, the pace of contraction in shadow-bank loans climbed. At this rate of deceleration, credit growth will undershoot the government’s 2021 target, which is expected to be in line with this year’s nominal GDP growth. The pace in credit expansion on a year-over-year basis has dropped to its previous cycle’s trough (Chart 7). Moreover, the speed of the deceleration in credit growth has outpaced the 2017/18 tightening cycle. It has been seven months since Chinese credit growth peaked (October 2020), which is significantly less than the 13 months it took for credit to decline from top to bottom in 2017/18. Chart 6Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Chart 7Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Chart 8Most Of LG Bonds Issued In The First Five Months Are Refinancing Bonds The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks So far this year, LG bond issuance is also behind schedule. About 63% of LG bonds issued in the first five months are refinancing bonds (Chart 8). The new LG bonds and LG SPBs issued to date account for only 21% and 16.5%, respectively, of their 2021 quotas. A delay in LG bond issuance in the first five months means that much more bonds will be on the market between June and October, which may help to stabilize credit growth in Q3. However, weak corporate bond financing and an acceleration in contracting shadow banking activities will cap the upside on broad credit. We do not expect a reversal in policy tightening. Instead, credit growth will likely hover near current levels for the rest of the year. In the past, Chinese policymakers eased when the global manufacturing backdrop faltered. Given that global growth is robust, Chinese policymakers will not feel any urgency to reverse policy setting and will likely use the strong external environment as an opportunity for domestic deleveraging. Chinese Exports Will Face Challenges In The Second Half Of The Year Chart 9A Broad-Based Moderation In China's Exports to DMs A Broad-Based Moderation In China's Exports to DMs A Broad-Based Moderation In China's Exports to DMs Export growth slowed in May with a broad-based moderation in the country’s exports to developed markets (DMs), albeit from a very elevated level (Chart 9). The easing in exports reflects an ongoing demand shift in the DMs away from goods to services as economic activity normalizes (Chart 10). China’s robust exports, which have been driven by strong and partly pandemic-induced global demand for goods, will likely gradually lose strength in the second half of the year. China’s weakening new export orders component in the May manufacturing PMI reflects this trend (Chart 11). Chart 10Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Chart 11China's Softening New Export Orders Signal Further Export-Sector Weakness China's Softening New Export Orders Signal Further Export-Sector Weakness China's Softening New Export Orders Signal Further Export-Sector Weakness An appreciating RMB versus the US dollar is also a headwind for Chinese exports. The USD/CNY historically has led Chinese new export orders by around six months, with the exception of the pandemic-hit outlier in 2020 (Chart 12).  The recent sharp RMB appreciation is starting to weight on Chinese exports. Moreover, BCA’s Geopolitical strategists do not expect that China will principally benefit from US President Biden’s $2.4 trillion infrastructure and green energy plan . US explicitly aims to diminish China’s role as a supplier of US goods and materials. The widening divergence between US’s trade deficit with China and the rest of world already shows evidence (Chart 13). Chart 12The RMB's Rapid Rise Creates Headwinds For Chinese Exports The RMB's Rapid Rise Creates Headwinds For Chinese Exports The RMB's Rapid Rise Creates Headwinds For Chinese Exports Chart 13China's Exports May Not Benefit From Biden's Infrastructure Plan China's Exports May Not Benefit From Biden's Infrastructure Plan China's Exports May Not Benefit From Biden's Infrastructure Plan Still No Inflation Pass-Through Chart 14Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese surging producer prices overstate domestic inflationary pressures. Inflation in the Producer Price Index (PPI) surged by 9.0% year-over-year in May, jumping to its highest level since 2009. High PPI inflation reflects rising commodity prices and a low base effect. Meanwhile, inflationary pressures are much more muted for consumer goods and services. The gap between producer and consumer prices widened to the highest level since 1990, highlighting the absence of price inflation pass-through from producers to consumers (Chart 14). We expect soaring PPI inflation to be transitory; it will ease when low-base factors from last year and global supply constraints are removed later this year. CPI inflation will remain tame through the year. As such, Chinese authorities are unlikely to tighten monetary policy in response to high PPI readings. Instead, Beijing will continue to use regulatory measures to curb speculation in the commodity market and window-guide industries to readjust material inventories to help ease the pace of rising commodity prices. Historically, PPI inflation’s impact on consumer prices has been weak when prices on producer goods were pushed up by supply shocks rather than mounting domestic demand. The sharp uptick in the PPI during the 2017/18 cycle was mostly due to China’s supply-side reforms and a rapid consolidation in the upstream industries. Global supply constraints linked to the pandemic have also resulted in a sharp upturn in the Chinese PPI since mid-2020. Moreover, Chart 15 shows that the pass-through from PPI inflation to consumers is closely correlated to household income growth. The pass-through has weakened significantly since 2011 when household income growth subdued along with a declining Chinese working population (Chart 16). Chart 15Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Chart 16Income Growth Decelerated After China's Working Population Peaked Income Growth Decelerated After China's Working Population Peaked Income Growth Decelerated After China's Working Population Peaked Chart 17Profits Diverged Between Upstream And Mid & Downstream Industries The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks Lacking inflation pass-through from producers to consumers has led to a bifurcated profit recovery between upstream and mid & downstream industries. Since late last year, the share of upstream industries in total profits increased sharply at the expense of mid and downstream businesses (Chart 17). A deterioration in the profits of mid and downstream industries will weigh on the outlook for their capex, which in turn, will reduce the demand for upstream goods.     Domestic Demand Remains China’s Weakest Link Investments and household demand remain the weakest links in China’s economy. Sluggish household consumption reflects a fragile post-pandemic recovery in manufacturing and services employment, and a rising propensity for precautionary savings (Chart 18). A PBoC survey shows that households’ preference for more saving deposits soared in 2020 (Chart 19). Although it has slightly diminished since late 2020, the reading is still much higher than its pre-pandemic level and will likely persist to year-end on the back of a subdued outlook for employment and income. Chart 18Weak Employment In Both Manufacturing And Service Industries Weak Employment In Both Manufacturing And Service Industries Weak Employment In Both Manufacturing And Service Industries Chart 19Propensity For Precautionary Savings Is Still Elevated Propensity For Precautionary Savings Is Still Elevated Propensity For Precautionary Savings Is Still Elevated Manufacturing investment continued its rebound in April, but the growth has not rallied to its pre-pandemic state and the recovery was more than offset by falling old-economy infrastructure and real estate investment growth (Chart 20). Although a pickup in LG SPB issuance in Q3 will provide some support to infrastructure expenditures, the effect on aggregate infrastructure investment probably will be muted. China’s Ministry of Finance has raised the requirements for approvals of new investment projects, which have decreased notably since early this year (Chart 21). Hence, growth in infrastructure investment may not significantly improve in 2H21 without a harmonized policy impetus for more bank loans and loosened regulations on local government spending. Chart 20Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Chart 21Falling New Projects Approval Falling New Projects Approval Falling New Projects Approval Real Estate Sector: Mounting Deleverage Pressure Property developers face challenges from heightened government scrutiny on bank loans and limits on the sector’s leverage ratio, along with curtailed off-balance sheet funding due to Asset Management Regulation (AMR) . Bank loans to real estate developers and household mortgages have tumbled to historical lows and will likely slow further in the next few months (Chart 22, top panel). The tightened financing policies have started to cool demand in the real estate market (Chart 22, bottom panel). Softer housing demand will start to drag down property developers’ capital spending and real estate construction activities (Chart 23). Chart 22Deteriorating Financing Starting To Cool The Property Market Deteriorating Financing Starting To Cool The Property Market Deteriorating Financing Starting To Cool The Property Market Chart 23Real Estate Investments And Construction Activities May Slow Further Real Estate Investments And Construction Activities May Slow Further Real Estate Investments And Construction Activities May Slow Further   Table 1China Macro Data Summary The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks Table 2China Financial Market Performance Summary The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks   Footnotes Cyclical Investment Stance Equity Sector Recommendations

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

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Norway's Vaccination Progress Norway's Vaccination Progress Chart 2Mobility Will Pick Up Mobility Will Pick Up Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well The Norwegian Method The Norwegian Method Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Positive Household Fundamentals Positive Household Fundamentals Chart 6Consumption Will Improve Further Consumption Will Improve Further Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The Norwegian Method The Norwegian Method The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Capital Spending Is Important For Norway Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 The Norwegian Method The Norwegian Method Chart 12Gas Production Is Rising In Importance The Norwegian Method The Norwegian Method Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation The Norwegian Method The Norwegian Method Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last The Norwegian Method The Norwegian Method According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Norwegian Method The Norwegian Method The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I The Dutch Disease, Part I The Dutch Disease, Part I Chart 23The Dutch Disease, Part II The Dutch Disease, Part II The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency NOK Is A Procyclical Currency NOK Is A Procyclical Currency Chart 26NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown The Norwegian Method The Norwegian Method That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Oslo Beats New York Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Favor Norway Over The Euro Area Favor Norway Over The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021.

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Norway's Vaccination Progress Norway's Vaccination Progress Chart 2Mobility Will Pick Up Mobility Will Pick Up Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well The Norwegian Method The Norwegian Method Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Positive Household Fundamentals Positive Household Fundamentals Chart 6Consumption Will Improve Further Consumption Will Improve Further Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The Norwegian Method The Norwegian Method The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Capital Spending Is Important For Norway Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 The Norwegian Method The Norwegian Method Chart 12Gas Production Is Rising In Importance The Norwegian Method The Norwegian Method Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation The Norwegian Method The Norwegian Method Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last The Norwegian Method The Norwegian Method According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Norwegian Method The Norwegian Method The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I The Dutch Disease, Part I The Dutch Disease, Part I Chart 23The Dutch Disease, Part II The Dutch Disease, Part II The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency NOK Is A Procyclical Currency NOK Is A Procyclical Currency Chart 26NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown The Norwegian Method The Norwegian Method That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Oslo Beats New York Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Favor Norway Over The Euro Area Favor Norway Over The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades