United States

Highlights Chart 1Still Close To Fair Value Still Close To Fair Value Still Close To Fair Value Treasury yields fell significantly in July, particularly at the long end of the curve. We continue to view this move as an overreaction to mediocre economic data that will be reversed this fall when labor supply constraints ease and employment surprises to the upside. It’s important to note, however, that despite the drop in long-dated yields the 5-year/5-year forward Treasury yield remains within the bounds of its 1.75% to 2.5% fair value range (Chart 1). That is, shorter-maturity Treasury yields have much more upside than long-dated yields on a 6-12 month investment horizon. We expect the next big move in bonds to be a bear-flattening of the yield curve as the market prices in a Fed rate hike cycle that we see starting near the end of 2022. Investors should position for that outcome today by keeping portfolio duration low and by entering yield curve flatteners. Feature Table 1Recommended Portfolio Specification It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 2Fixed Income Sector Performance It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +172 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 89 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated EM sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 3BCorporate Sector Risk Vs. Reward* It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +433 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first six months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in July, dragging year-to-date excess returns down to -64 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 8 bps in July. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 3 bps in July (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 36 bps, below the 54 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 34 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +57 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 149 bps in July, dragging year-to-date excess returns down to -113 bps. Foreign Agencies underperformed the Treasury benchmark by 11 bps on the month, dragging year-to-date excess returns down to +35 bps. Local Authority bonds underperformed by 19 bps in July, dragging year-to-date excess returns down to +372 bps. Domestic Agency bonds outperformed by 2 bps, bringing year-to-date excess returns up to +28 bps. Supranationals performed in line with Treasuries in July, year-to-date excess returns held flat at +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +271 bps (before adjusting for the tax advantage). The economic and policy back-drop is favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 10% breakeven tax rate versus corporates with the same credit rating and duration. The breakeven tax rate for Revenue munis is just 2% (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in July. Bond yields were down across the curve, but by much more at the long end. The 2-year/10-year slope flattened 15 bps to end the month at 105 bps. The 5-year/30-year slope steepened 1 bp to end the month at 120 bps. While we expect the recent decline in bond yields to reverse during the next 6-12 months, we do not think this reversal will coincide with a re-steepening of the 2/10 yield curve. We noted on the first page of this report that the 5-year/5-year forward Treasury yield remains close to its fair value range. Last week’s report demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.17% in one year’s time and 1.36% in five years (Chart 7). While the latter rate has 157 bps of upside if it converges all the way back to its 2018 high, this pales in comparison to the 269 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.   TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in July, bringing year-to-date excess returns up to +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose by 9 bps and 8 bps, respectively, on the month. At 2.43%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to +37 bps. Aaa-rated ABS underperformed by 3 bps on the month, dragging year-to-date excess returns down to +28 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +88 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile, pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in July, bringing year-to-date excess returns up to +187 bps. Aaa Non-Agency CMBS performed in-line with Treasuries in July, keeping year-to-date excess returns steady at +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 16 bps on the month, bringing year-to-date excess returns up to +539 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 28 basis points in July, dragging year-to-date excess returns down to +87 bps. The average index option-adjusted spread widened 5 bps on the month and it currently sits at 34 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 26 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 26 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Dear Client, This week, in lieu of our regular report, I am sending you a special report written by my colleague Jonathan LaBerge, chief strategist of our flagship The Bank Credit Analyst service. Jonathan argues that investors should see social media as a technological innovation that harms productivity. While Jonathan concedes that social media was not the main driver of policy uncertainty and political risk over the past decade, he makes a good case that it plays an aggravating role. He warns that social media and political polarization still pose risks to the macroeconomic outlook in the coming years, while also highlighting idiosyncratic risks threatening social media stocks. We trust that you will find this report insightful. We will resume regular publication next week. All very best, Matt Gertken   Vice President Geopolitical Strategy US Political Strategy BCA Research Highlights Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. The cyclical component of productivity was long lasting in nature during the last economic expansion. Forces that negatively impact economic growth but do not change the factors of production necessarily reduce measured productivity, and repeated policy mistakes strongly contributed to the slow growth profile of the last economic cycle. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. The risks of additional mistakes from populism remain present, even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation. A potential revival in protectionist sentiment is a risk to a constructive cyclical view that we will be closely monitoring over the coming 12-24 months. Investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing these companies from the public’s impression of the impact of social media on society – especially if social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case). Feature Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. While the risk of premature fiscal consolidation appears low today compared to the 2010-14 period, the pandemic and its aftermath could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year in the lead up to the 2022 mid-term elections. The midterms, for their part, are expected to bring gridlock back into US politics, which could remove fiscal options should the economy backslide. Frequent shocks during the last economic expansion reinforced the narrative of secular stagnation. In the coming years, any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates – despite the case for cyclically and structurally higher bond yields. In addition, investors with concentrated positions in social media companies should take seriously the long-term idiosyncratic risks facing these stocks. These risks stem from the public’s impression of the impact of social media on society, particularly if social media comes to be widely associated with political gridlock, the polarization of society, and failed economic policies. A Brief History Of Social Media The earliest social networking websites date back to the late 1990s, but the most influential social media platforms, such as Facebook and Twitter, originated in the mid-2000s. Prior to the advent of modern-day smartphones, user access to platforms such as Facebook and Twitter was limited to the websites of these platforms (desktop access). Following the release of the first iPhone in June 2007, however, mobile social media applications became available, allowing users much more convenient access to these platforms. Charts 1 and 2 highlight the impact that smartphones have had on the spread of social media, especially since the release of the iPhone 3G in 2008. In 2006, Facebook had roughly 12 million monthly active users; by 2009, this number had climbed to 360 million, growing to over 600 million the year after. Twitter, by contrast, grew somewhat later, reaching 100 million monthly active users in Q3 2011. Social media usage is more common among those who are younger, but Chart 3 highlights that usage has risen over time for all age groups. As of Q1 2021, 81% of Americans aged 30-49 reported using at least one social media website, compared to 73% of those aged 50-64 and 45% of those aged 65 and over. Chart 4 highlights that the usage of Twitter skews in particular toward the young, and that, by contrast, Facebook and YouTube are the social media platforms of choice among older Americans. Chart 1Facebook: Monthly Active Users The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 2Twitter: Monthly Active Users Worldwide The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 3A Sizeable Majority Of US Adults Regularly Use Social Media A Sizeable Majority Of US Adults Regularly Use Social Media A Sizeable Majority Of US Adults Regularly Use Social Media Chart 4Older Americans Use Facebook Far More Than Twitter The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth As a final point documenting the development and significance of social media, Chart 5 highlights that more Americans now report consuming news often (roughly once per day) from a smartphone, computer, or tablet other than from television. Radio and print have been completely eclipsed as sources of frequent news. The major news publications themselves are often promoted through social media, but the rise of the Internet has weighed heavily on the journalism industry. Social media has, for better and for worse, enabled the rapid proliferation of alternative news, citizen journalism, rumor, conspiracy theories, and foreign disinformation. Chart 5Social Media Has Changed The Way People Consume News The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Link Between Social Media And Post-GFC Austerity Following the 2008-2009 global financial crisis (GFC), there have been at least five deeply impactful non-monetary shocks to the US and global economies that have contributed to the disconnection between growth and interest rates: A prolonged period of US household deleveraging from 2008-2014 The Euro Area sovereign debt crisis Fiscal austerity in the US, UK, and Euro Area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The rise of populist economic policies, such as the UK decision to leave the European Union, and the US-initiated trade war of 2018-2019. Among these shocks to growth, social media has had a clear impact on two of them. In the case of austerity in the aftermath of the Great Recession, a sharp rise in fiscal conservatism in 2009 and 2010, emblematized by the rise of the US Tea Party, profoundly affected the 2010 US midterm elections. It is not surprising that there was a fiscally conservative backlash following the crisis: the US budget deficit and debt-to-GDP ratio soared after the economy collapsed and the government enacted fiscal stimulus to bail out the banking system. And midterm elections in the US often lead to significant gains for the opposition party However, Tea Party supporters rapidly took up a new means of communicating to mobilize politically, and there is evidence that this contributed to their electoral success. Chart 6 illustrates that the number of tweets with the Tea Party hashtag rose significantly in 2010 in the lead-up to the election, which saw the Republican Party take control of the House of Representatives as well as the victory of several Tea Party-endorsed politicians. Table 1 highlights that Tea Party candidates, who rode the wave of fiscal conservatism, significantly outperformed Democrats and non-Tea Party Republicans in the use of Twitter during the 2010 campaign, underscoring that social media use was a factor aiding outreach to voters. Chart 6Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Table 1Tea Party Candidates Significantly Outperformed In Their Use Of Social Media The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth And while it is more difficult to analyze the use and impact of Facebook by Tea Party candidates and supporters owing to inherent differences in the structure of the Facebook platform, interviews with core organizers of both the Tea Party and Occupy Wall Street movements have noted that activists in these ideologically opposed groups viewed Facebook as the most important social networking service for their political activities.1 Under normal circumstances, we agree that fiscal policy should be symmetric, with reduced fiscal support during economic expansions following fiscal easing during recessions. But in the context of multi-year household deleveraging, the fiscal drag that occurred in following the 2010 midterm elections was clearly a policy mistake. This mistake occurred partially under full Democratic control of government and especially under a gridlocked Congress after 2010. Chart 7 highlights that the contribution to growth from government spending turned sharpy negative in 2010 and continued to subtract from growth for some time thereafter. In addition, panel of Chart 7 highlights that the US economic policy uncertainty index rose in 2010 after falling during the first year of the recovery, reaching a new high in 2011 during the Tea Party-inspired debt ceiling crisis. Chart 7The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake In addition to the negative impact of government spending on economic growth, this extreme uncertainty very likely damaged confidence in the economic recovery, contributing to the subpar pace of growth in the first half of the last economic expansion. Chart 8 highlights the weak evolution in real per capita GDP from 2009-2019 compared with previous economic cycles, which was caused by a prolonged household balance sheet recovery process that was made worse by policy mistakes. To be sure, the UK and the EU did not have a Tea Party, and yet political elites imposed fiscal austerity. It is also the case that President Obama was the first president to embrace social media as a political and public relations tool. So it cannot be said that either social media or the Republican Party are uniquely to blame for the policy mistakes of that era. But US fiscal policy would have been considerably looser in the 2010s if not for the Tea Party backlash, which was partly enabled by social media. Too tight of fiscal policy in turn fed populism and produced additional policy mistakes down the road. Chart 8Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile From Fiscal Drag To Populism While social media is clearly not the root cause of the recent rise of populist policies, it has had a hand in bringing them about – in both a direct and indirect manner. The indirect link between social media use and the rise in populist policies has mainly occurred through the highly successful use of social media by international terrorist organizations (chiefly ISIL) and its impact on sentiment toward immigration in several developed market economies. Chart 9 highlights that public concerns about immigration and race in the UK began to rise sharply in 2012, in lockstep with both the rise in UK immigrants from EU accession countries and a series of events: the Syrian refugee crisis, the establishment and reign of the Islamic State, and three major terrorist attacks in European countries for which ISIL claimed responsibility. Given that the main argument for “Brexit” was for the UK to regain control over its immigration policies, these events almost certainly increased UK public support for withdrawing from the EU. In other words, it is not clear that Brexit would have occurred (at least at that moment in time) without these events given the narrow margin of victory for the “leave” campaign. The absence of social media would not have prevented the rise of ISIL, as that occurred in response to the US’s precipitous withdrawal from Iraq. The inevitable rise of ISIL would still have generated a backlash against immigration. Moreover, fiscal austerity in the UK and EU also fed other grievances that supported the Brexit movement. But social media accelerated and amplified the entire process.  Chart 10 presents fairly strong evidence that Brexit weakened UK economic performance relative to the Euro Area prior to the pandemic, with the exception of the 2018-2019 period. In this period Euro Area manufacturing underperformed during the Trump administration’s trade war as a result of its comparatively higher exposure to automobile production and its stronger ties to China. Panel 2 highlights that GBP-EUR fell sharply in advance of the referendum, and remains comparatively weak today. Chart 9Terrorism And Immigration Likely Contributed To Brexit Terrorism And Immigration Likely Contributed To Brexit Terrorism And Immigration Likely Contributed To Brexit Chart 10Brexit Weakened UK Economic Performance Prior To The Pandemic Brexit Weakened UK Economic Performance Prior To The Pandemic Brexit Weakened UK Economic Performance Prior To The Pandemic Turning to the US, Donald Trump’s election as US President in 2016 was aided by both the direct and indirect effects of social media. In terms of indirect effects, Trump benefited from similar concerns over immigration and terrorism that caused the UK to leave the EU: Chart 11 highlights that terrorism and foreign policy were second and third on the list of concerns of registered voters in mid-2016, and Chart 12 highlights that voters regarded Trump as the better candidate to defend the US against future terrorist attacks. Chart 11Terrorism Ranked Highly As An Issue In The 2016 US Election The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 12Voters Regarded Trump As Better Equipped To Defend Against Terrorism The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Trump’s election; and the enactment of populist policies under his administration, were directly aided by Trump’s active use of social media (mainly Twitter) to boost his candidacy. Chart 13 highlights that there were an average of 15-20 tweets per day from Trump’s Twitter account from 2013-2015, and 80% of those tweets occurred before he announced his candidacy for president in June 2015. This strongly underscores that Trump mainly used Twitter to lay the groundwork for his candidacy as an unconventional political outsider rather than as a campaign tool itself, which distinguishes his use of social media from that of other politicians. In other words, new technology disrupted the “good old boys’ club” of traditional media and elite politics. Chart 13Trump Used Twitter To Lay The Groundwork For His Candidacy Trump Used Twitter To Lay The Groundwork For His Candidacy Trump Used Twitter To Lay The Groundwork For His Candidacy Chart 14The Trump Tax Cuts A Huge Rise In Corporate Earnings The Trump Tax Cuts A Huge Rise In Corporate Earnings The Trump Tax Cuts A Huge Rise In Corporate Earnings Some policies of the Trump administration were positive for financial markets, and it is fair to say that Trump fired up animal spirits to some extent: Chart 14 highlights that the Tax Cuts and Jobs Act caused a significant rise in stock market earnings per share. But the Trump tax cuts were a conventional policy pushed mostly by the Congressional leadership of the Republican Party, and they did not meaningfully boost economic growth. Chart 15 highlights that, while the US ISM manufacturing index rose sharply in the first year of Trump’s administration, an uptrend was already underway prior to the election as a result of a significant improvement in Chinese credit growth and a recovery in oil prices after the devastating collapse that took place in 2014-2015. Chart 15But The Tax Cuts Did Not Do Much To Boost Growth But The Tax Cuts Did Not Do Much To Boost Growth But The Tax Cuts Did Not Do Much To Boost Growth Similarly, Chart 15 highlights that the Trump trade war does not bear the full responsibility of the significant slowdown in growth in 2019, as China’s credit impulse decelerated significantly between the passage of the Tax Cuts and Jobs Act and the onset of the trade war because Chinese policymakers turned to address domestic concerns. But Chart 16 highlights that the aggressive imposition of tariffs, especially between the US and China, caused an explosion in trade uncertainty even when measured on an equally-weighted basis (i.e., when overweighting trade uncertainty, in countries other than the US and China), which undoubtedly weighed on the global economy and contributed to a very significant slowdown in US jobs growth in 2019 (panel 2). Moreover, Chinese policymakers responded to the trade onslaught by deleveraging, which weighed on the global economy; and consolidating their grip on power at home. In essence, Trump was a political outsider who utilized social media to bypass the traditional media and make his case to the American people. Other factors contributed to his surprising victory, not the least of which was the austerity-induced, slow-growth recovery in key swing states. While US policy was already shifting to be more confrontational toward China, the Trump administration was more belligerent in its use of tariffs than previous administrations. The trade war thus qualifies as another policy shock that was facilitated by the existence of social media. Chart 16The Trade War Caused An Explosion In Global Trade Uncertainty The Trade War Caused An Explosion In Global Trade Uncertainty The Trade War Caused An Explosion In Global Trade Uncertainty Viewing Social Media As A Negative Productivity-Innovation A rise in fiscal conservatism leading to misguided austerity, the UK’s decision to leave the European Union, and the Trump administration’s trade war have represented significant non-monetary shocks to both the US and global economies over the past 12 years. These shocks strongly contributed to the subpar growth profile of the last economic expansion, as demonstrated above. Given the above, it is reasonable for investors to view social media as a technological innovation with negative productivity growth, given that it has facilitated policy mistakes during the last economic expansion. Chart 17 underscores this point, by highlighting that multi-factor productivity growth has been extremely weak in the post-GFC environment. While productivity is usually driven by supply-side factors over the longer term, it has a cyclical component to it – and in the case of the last economic expansion, the cyclical component was long lasting in nature. Any forces negatively impacting economic growth that do not change the factors of production necessarily reduce measured productivity; it is for this reason that measured productivity declines during recessions; and policy mistakes negatively impact productivity growth. Chart 17Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Chart 18State & Local Government Finances Are In Much Better Shape Today State & Local Government Finances Are In Much Better Shape Today State & Local Government Finances Are In Much Better Shape Today The Risk Of Aggressive Austerity Seems Low Today… Fiscal austerity in the early phase of the last economic cycle was the first social media-linked shock that we identified, but the risk of aggressive austerity appears low today. Much of the fiscal drag that occurred in the aftermath of the global financial crisis happened because of insufficient financial support to state and local governments – and the subsequent refusal by Congress to authorize more aid. But Chart 18 highlights that state and local government finances have already meaningfully recovered, on the back of bipartisan stimulus in 2020, while the American Rescue Plan provides significant additional funding. While it is true that US fiscal policy is set to detract from growth over the coming 6-12 months, this will merely reflect the unwinding of fiscal aid that had aimed to support household income temporarily lost, as a result of a drastic reduction in services spending. As we noted in last month’s report,2 goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the deployment of some of the sizable excess savings that US households have accumulated over the past year. Fiscal drag will also occur outside of the US next year. For example, the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, which would represent the largest annual increase over the past two decades. But here too the reduction in government spending will reflect the end of pandemic-related income support, and is likely to occur alongside a positive private-sector services impulse. During the worst of the Euro Area sovereign debt crisis, the impact of austerity was especially acute because it was persistent, and it occurred while the output gap was still large in several Euro Area economies. Chart 19 highlights that Euro Area fiscal consolidation from 2010-2013 was negatively correlated with economic activity during that period, and Chart 20 highlights that, with the potential exception of Spain, this austerity does not appear to have led to subsequently stronger rates of growth. Chart 19Euro Area Austerity Lowered Growth During The Consolidation Phase… The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 20…And Did Not Seem To Subsequently Raise Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth This experiment in austerity led the IMF to conclude that fiscal multipliers are indeed large during periods of substantial economic slack, constrained monetary policy, and synchronized fiscal adjustment across numerous economies.3 Similarly, attitudes about austerity have shifted among policymakers globally in the wake of the populist backlash. Given this, despite the significant increase in government debt levels that has occurred as a result of the pandemic, we strongly doubt that advanced economies will attempt to engage in additional austerity prematurely, i.e., before unemployment rates have returned close-to steady-state levels. …But The Risk Of Protectionism And Other Populist Measures Looms Large The role that social media has played at magnifying populist policies should be concerning for investors, especially given that there has been a rising trend towards populism over the past 20 years. In a recent paper, Funke, Schularick, and Trebesch have compiled a cross-country database on populism dating back to 1900, defining populist leaders as those who employ a political strategy focusing on the conflict between “the people” and “the elites.” Chart 21 highlights that the number of populist governments worldwide has risen significantly since the 1980s and 1990s, and Chart 22 highlights that the economic performance of countries with populist leaders is clearly negative. Chart 21Populism Has Been On The Rise For The Past 30 Years The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The authors found that countries’ real GDP growth underperformed by approximately one percentage point per year after a populist leader comes to power, relative to both the country’s own long-term growth rate and relative to the prevailing level of global growth. To control for the potential causal link between economic growth and the rise of populist leaders, Chart 23 highlights the results of a synthetic control method employed by the authors that generates a similar conclusion to the unconditional averages shown in Chart 22: populist economic policies are significantly negative for real economic growth. Chart 22Populist Leaders Are Clearly Growth Killers Even After… The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth Chart 23… Controlling For The Odds That Weak Growth Leads To Populism The Social Media Magnification Effect: Austerity, Populism, And Slower Growth The Social Media Magnification Effect: Austerity, Populism, And Slower Growth This is especially concerning given that wealth and income inequality, perhaps the single most important structural cause of rising populism and political polarization, is nearly as elevated as it was in the 1920s and 1930s (Chart 24). This trend, at least in the US, has been exacerbated by a decline in public trust of mainstream media among independents and Republicans that began in the early 2000s and helped to fuel the public’s adoption of alternative news and social media. The decline in trust clearly accelerated as a result of erroneous reporting on what turned out to be nonexistent weapons of mass destruction in Iraq and other controversies of the Bush administration. Chart 21 showed that the rise in populism has also yet to abate, suggesting that social media has the potential to continue to amplify policy mistakes for the foreseeable future. Chart 24Inequality: The Most Important Structural Cause Of Populism And Polarization Inequality: The Most Important Structural Cause Of Populism And Polarization Inequality: The Most Important Structural Cause Of Populism And Polarization It is not yet clear what economic mistakes will occur under the Biden administration, but investors should not rule out the possibility of policies that are harmful for growth. The likely passage of a bipartisan infrastructure bill or a partisan reconciliation bill in the second half of this year will most likely be the final word on fiscal policy until at least 2025,4 underscoring that active fiscal austerity is not likely a major risk to investors. Spending levels will probably freeze after 2022: Republicans will not be able to slash spending, and Democrats will not be able to hike spending or taxes, if Republicans win at least one chamber of Congress in the midterms (as is likely). Biden has preserved the most significant of Trump’s protectionist policies by maintaining US import tariffs against China, and the lesson from the Tea Party’s surge following the global financial crisis is that major political shifts, magnified by social media, can manifest themselves as policy with the potential to impact economic activity within a two-year window. Attitudes toward China have shifted negatively around the world because of deindustrialization and now the pandemic.5 White collar workers in DM countries have clearly fared better during lockdowns than those of lower-income households. This has created extremely fertile ground for a revival in populist sentiment, which could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year, in the lead up to the 2022 mid-term elections. Investment Conclusions In this report, we have documented the historical link between social media, populism, and policy mistakes during the last economic expansion. It is clear that neither social media nor even populism is solely responsible for all mistakes – the UK’s and EU’s ill-judged foray into austerity was driven by elites. Furthermore, we have not addressed in this report the impact of populism on actions of emerging markets, such as China and Russia, whose own behavior has dealt disinflationary blows to the global economy. Nevertheless, populism is a potent force that clearly has the power to harness new technology and deliver shocks to the global economy and financial markets. The risks of additional mistakes from populism are still present, and that is even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation – contributing to the vaccine hesitancy in some DM countries that we discussed in Section 1 of our report. Two investment conclusions emerge from our analysis. First, we noted in our April report that there is a chance that investor expectations for the natural rate of interest (“R-star”) will rise once the economy normalizes post-pandemic, but that this will likely not occur as long as investors continue to believe in the narrative of secular stagnation. Despite the fact that the past decade’s shocks occurred against the backdrop of persistent household deleveraging (which has ended in the US), these shocks reinforced that narrative, and any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates. Thus, while the rapid closure of output gaps in advanced economies over the coming year argues for both cyclically and structurally higher bond yields, a revival in protectionist sentiment is a risk to this view that we will be closely monitoring over the coming 12-24 months. Second, for tech investors, the bipartisan shift in public sentiment to become more critical of social media companies is gradually becoming a real risk, potentially affecting user growth. Based solely on Facebook, Twitter, Pinterest, and Snapchat, social media companies do not account for a very significant share of the overall equity market (Chart 25), suggesting that the impact of a negative shift in sentiment toward social media companies would not be an overly significant event for equity investors in general. Chart 25 highlights that the share of social media companies as a percent of the broad tech sector rises if Google is included; YouTube accounts for less than 15% of Google’s total advertising revenue, however, suggesting modest additional exposure beyond the solid line in Chart 25. Chart 25The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market Still, investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing social media companies as a result of the public’s impression of the impact of social media on society. If social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case), then the fundamental performance of these stocks is likely to be quite poor regardless of whether or not tech companies ultimately enjoy a relatively friendly regulatory environment under the Biden administration.   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1     Grassroots Organizing in the Digital Age: Considering Values and Technology in Tea Party and Occupy Wall Street by Agarwal, Barthel, Rost, Borning, Bennett, and Johnson, Information, Communication & Society, 2014. 2     Please see The Bank Credit Analyst “July 2021,” dated June 24, 2021, available at bca.bcaresearch.com 3    “Are We Underestimating Short-Term Fiscal Multipliers?”,IMF World Economic Outlook, October 2012 4    Please see US Political Strategy Outlook "Third Quarter Outlook 2021: Game Time," dated June 30, 2021, available at usps.bcaresearch.com 5    “Unfavorable Views of China Reach Historic Highs in Many Countries,” PEW Research Center, October 2020.

Highlights The countertrend yield rally is near its end. Despite the deteriorating Chinese credit impulse, the outlook for global growth remains robust. An ample global liquidity backdrop, an inventory restocking cycle, and an upbeat capex outlook will increase aggregate demand and global capacity utilization. In this context, safe-haven bonds have sufficiently rallied. German yields will rise too, because the European yield curve will steepen. European banks will benefit from this trend. Investors should buy European momentum stocks and sell growth stocks. Investors should favor industrial equities and Sweden. Feature On April 12 of this year, we warned that a countertrend rally in bonds was increasingly likely. The decline in the Chinese credit impulse and the increasingly oversold state of Treasuries created the perfect conditions to generate disappointments in a lopsided market. As a corollary, we grew worried about our equity positioning, which calls for a large exposure to pro-cyclical stocks. Consequently, we recommended investors hedge this portfolio bias with some defensive bets. On July 20, Treasury yields fell to as low as 1.13%. Did this level mark the end of the Treasury rally? The bulk of the decline is behind us, and investors with a 12- to 18-month investment horizon should resume shortening portfolio duration. In Europe too, German yields are likely to trend higher. As a result, European financials and momentum stocks should generate significant outperformance in the coming quarters. Industrial equities are also set to shine, which will benefit the Swedish market, our favorite. Should I Stay Or Should I Go? The near-term outlook for Treasuries is currently more complex than it was in April, when forces lined up neatly to warn of an imminent pullback in yields. Technical indicators show that the oversold conditions that prevailed this spring have mostly cleared up. In April, the BCA Composite Technical Indicator for Treasuries reached its most oversold level in more than 20 years, which provided a very reliable buy signal (Chart 1). Now that the 10-year yield has reclaimed its 40-week moving average, the technical indicator is back to neutral. Normally, when bonds are in a cyclical bear market, which is BCA’s House View, the indicator rarely dips significantly into overbought territory. Meanwhile, the Marketvane Bullish Sentiment survey stands at 60%, which indicates that bonds are once again favored by many newsletters, traders, and investors. Chinese credit growth continues to send a bond-bullish signal (Chart 2). Slowing credit growth could hurt Chinese capex, which in turn has the potential to slow the demand for capital at the global level. This risk could still decrease global yields. Chart 1Bonds Are Not Oversold Anymore... Bonds Are Not Oversold Anymore... Bonds Are Not Oversold Anymore... Chart 2...But China Still Consistutes A Risk ...But China Still Consistutes A Risk ...But China Still Consistutes A Risk Chart 3A Synchronous Global Upswing A Synchronous Global Upswing A Synchronous Global Upswing The global economic recovery remains sufficiently broad-based to compensate for the risk of a Chinese slowdown. Our Global Synchronicity Indicator shows that manufacturing PMIs among the world’s major economies are all expanding (Chart 3), which usually elevates yields. This is especially important today, because the far-reaching and generalized nature of the current recovery gives more scope to the global economy to withstand a Chinese economic deceleration. Bottom Line: The variables that called for lower yields in early April are currently sending a mixed message. “Go!” The Global Business Cycle Responds Outside of China’s TSF impulse, most economic variables point toward higher yields. Chart 4Financial Liquidity Lifts The Business Cycle Financial Liquidity Lifts The Business Cycle Financial Liquidity Lifts The Business Cycle Global liquidity conditions remain consistent with higher growth and thus also with rising global interest rates. BCA’s US Financial Liquidity Index still stands near record highs and confirms that the Global Leading Economic Indicator (LEI) will remain at elevated levels (Chart 4). As a result, we expect the current fall in the Global LEI Diffusion Index to be short lived. Any softening in global growth, therefore, will prove to be transitory. Markets are forward looking. The recent decline in yields anticipated the deceleration in the Global LEI. Long-term rates will also increase before the LEI firms anew.  Excess money growth tells a similar story. Historically, an expansion of the global money supply in excess of the demand for credit sends a strong signal that global economic activity is well supported by reflationary policies. It forecasts above-trend industrial production growth, robust international trade and rising global export prices. Currently, excess money growth in the US, Eurozone and Japan has overtaken its post-GFC high and is consistent with higher US and German yields (Chart 5). Global capacity utilization also points toward higher yields. Our US Composite Capacity Utilization indicator is back in the neutral zone after a steep decline in 2020. Furthermore, US industrial capacity utilization is currently back above its structural trend. Most importantly, capacity utilization should be evaluated at the global level. Even when slower-growing economies such as the Euro Area and Japan are included, global capacity utilization is improving enough to be consistent with rising yields (Chart 6). Chart 5Excess Money Points To Higher Yields Excess Money Points To Higher Yields Excess Money Points To Higher Yields Chart 6Rising CAPU Lifts Yields Rising CAPU Lifts Yields Rising CAPU Lifts Yields Capacity utilization should climb higher in the coming quarters as the world experiences an inventory re-stocking cycle. The US, with its rich data, provides a good example. The sales-to-inventory ratio is at an extremely elevated level and is climbing very rapidly (Chart 7). Meanwhile, the level of inventories is still 1% below its pre-pandemic peak, while GDP overtook it previous high in the second quarter, and business sales are 11% above their 2018 high. The recent rise in inflation highlights the inability of companies to fulfil demand for their goods and services and, consequently, the need to restock. Hence, we expect companies to increase their inventory spending, which will add to demand and to capacity utilization as the adjustment process takes place. Capex will also lift capacity utilization and put upward pressure on yields. US capex intentions are rising swiftly as firms are unable to meet demand (Chart 8, top panel). Our Japanese Capex Indicator reiterates this message, while the European Commission’s Investment Surveys are also recovering (Chart 8 bottom panels). Historically, capex intentions are an excellent, leading indicator of actual investments, hence, the recent poor capex numbers will not last. Chart 7Restocking Ahead! Restocking Ahead! Restocking Ahead! Chart 8Climbing Capex Intentions Everywhere Climbing Capex Intentions Everywhere Climbing Capex Intentions Everywhere Greater global cash flow growth is also consistent with higher capex. The growth in EBITDA among global companies has bottomed, and it is currently around 14%. Incidentally, this suggests that capex among quoted firms around the world should expand in the second half of the year by a similar amount (Chart 9). Ultimately, robust cash flows finance expansion plans and also send a strong signal to corporate boards that the environment is ripe for investment spending. Already, capital goods orders are strengthening, which confirms the signal from both the capex surveys and profits. This strength portends very strong private capex numbers in the coming quarters and thus, a greater level of demand in the economy (Chart 10). Chart 9Rising Cash Flows Lead To Higher Capex Rising Cash Flows Lead To Higher Capex Rising Cash Flows Lead To Higher Capex Chart 10Strong Global Orders Strong Global Orders Strong Global Orders Public infrastructure plans will create the final boost to global capex. $550 billion of the Biden administration’s infrastructure plan is getting close to bipartisan approval, and the budget reconciliation process might still result in an even bigger package before yearend. In Europe, the EUR800 billion NGEU plan that has been approved by all the EU’s national parliaments also includes large infrastructure spending envelopes to deploy over the coming five years. This context suggests that yields are unlikely to decline much further from current levels, since the oversold conditions that prevailed in March have been purged. Chart 11 shows that specific events are needed to prompt a greater 90-trading day collapse in yields than the one just registered. In 2019 and 2020, the Fed was cutting rates. Today, it is gearing up to raise them. In 2010 and 2011, the European sovereign debt crisis was hurting global growth and creating massive deflationary risks. In 2015, China was mired in deep deflation and devalued the RMB, which exported these negative pressures around the world and lowered yields. By late 2018, the yield curve was moving toward an inversion, which signaled that monetary policy was too tight. Today, none of these conditions are present and, consequently, the odds of a greater decline in yields are low. Chart 11Yields Have Moved Enough Yields Have Moved Enough Yields Have Moved Enough Bottom Line: The broad-based nature of the global recovery will limit the decline in yields. Global liquidity conditions remain extremely accommodative, global capacity utilization is improving, and inventories and capex spending will add to demand in the coming quarters. In this context, the recent decline in yields corrected this spring’s oversold condition in the bond market sufficiently. Investment Implications Bonds Investors with an investment horizon of more than six months should reduce their portfolio duration and remove hedges protecting against higher yields. The low in Treasury yields is likely to stay around 1.1%. The exact timing of the rebound is imprecise, and yields could churn for a brief period and retest their recent lows, but the balance of risks points toward a much greater probability of higher yields in the coming six to twelve months, and a limited probability of significantly lower yields from current levels. In fact, the CRB-to-gold ratio, often shown by BCA’s US bond strategists, clearly favors higher yields (Chart 12). Higher yields are not inconsistent with BCA’s view that the current inflation spike is transitory. TIPS yields are at a record low. As global growth recovers and the Fed moves closer to removing some accommodation, real yields will increase (Chart 13, top panel). Meanwhile, 5-year/5-year forward inflation breakeven rates remain well below the 2.5%-to-3% zone that prevailed prior to 2014, when long-term inflation expectations were still well anchored (Chart 13, bottom panel). The Fed is actively aiming to push this inflation expectation measure higher. Chart 12The CRB/Gold Ratio Points To Higher Yields The CRB/Gold Ratio Points To Higher Yields The CRB/Gold Ratio Points To Higher Yields Chart 13TIPS Yields Will Rise TIPS Yields Will Rise TIPS Yields Will Rise Chart 14The European Yield Curve Will Steepen The European Yield Curve Will Steepen The European Yield Curve Will Steepen German yields have some upside too, even if the ECB will lag well behind the Fed in terms of both ending its QE program and lifting interest rates. The ECB policy rate mostly anchors the short end of the curve, and the large European excess savings warrant lower Bund yields than those of T-Note. However, the nominal and real terminal rates embedded in the German curve remain lower than at the apex of the European sovereign debt crisis and are extremely low compared to the US. As a result, the European yield curve will steepen, which is confirmed by the comparative strength of the earnings revisions of Europe’s cyclical equity sectors (Chart 14). Equities An environment in which yields rise again should favor financials, industrials, and momentum stocks at the expense of growth stocks. In Europe, banks and financials will be the prime beneficiaries of higher yields. Historically, higher German Bund yields are associated with an outperformance of banks relative to the broad market, because a steeper yield curve boosts net interest margins (Chart 15). European banks also have scope for some re-rating. There is little case to significantly upgrade the sectors’ expected long-term profitability significantly, considering that the European economy remains replete with an excessively large capital stock. Nonetheless, at a price-to-book ratio of 0.6 or 55% below that of US banks and 67% below the European broad market, European banks are also priced as risky investments. However, European NPLs have declined significantly, and the public sector support during the pandemic will limit how high NPLs can rise (Chart 16, top panel). Moreover, European banks are much better capitalized than they once were, which further decreases their riskiness (Chart 16). Additionally, the ECB has allowed banks to pay dividends again. Finally, the fiscal risk sharing created by the NGEU funds and continued bond purchases by the ECB will cap the upside for peripheral yield spreads, which will limit the odds of the emergence of the kind of doom-loop that once plagued the European banking system. UK bank stocks look particularly attractive.   Chart 15European Banks Have Upside European Banks Have Upside European Banks Have Upside Chart 16Less Risky Less Risky Less Risky The massive underperformance of European momentum stocks relative to growth stocks is also likely to reverse (Chart 17). As Chart 18 shows, momentum stocks currently trade at an exceptionally large discount to both growth stocks and the European broad market. Most importantly, momentum equities tend to outperform growth stocks in the wake of a rise in German yields (Chart 19). This sensitivity to yields is currently accentuated by the sector bias of momentum stocks. Relative to growth stocks, momentum equities greatest overweights are financials, industrials and materials (Table 1), three sectors that thrive on higher interest rates. Meanwhile, their largest relative underweights are consumer staples and healthcare, two sectors with strong defensive characteristics that benefit from lower yields.  Chart 17Bomned Out Momentum Stocks... Bomned Out Momentum Stocks... Bomned Out Momentum Stocks... Chart 18...Have Become Very Cheap ...Have Become Very Cheap ...Have Become Very Cheap Chart 19Momentum Stocks Outperform When Yields Rise Momentum Stocks Outperform When Yields Rise Momentum Stocks Outperform When Yields Rise Table 1Sector Biases: Momentum Vs Growth Stocks The Ageing Bond Rally The Ageing Bond Rally Chart 20The Capex Outlook Favors Industrials The Capex Outlook Favors Industrials The Capex Outlook Favors Industrials Finally, we recommend investors move more aggressively into industrial equities. Industrials are the best-placed sector to benefit from the rise in global capex and the excess money supply growth. As Chart 20 highlights, even if the rate of growth of global capital goods orders decelerates, industrials should outperform the European broad market as long as the rate of growth remains positive. Nonetheless, the sector’s outperformance could moderate because it has become more expensive than the broad market. However, a stronger profitability compensates for this negative. As a corollary, we continue to favor Swedish equities because of their 38% weight in industrials and 27% allocation to financials. Moreover, their superior return on equity and profit margins, as well as the EUR/SEK’s downside potential, add to Sweden’s allure. The largest risk for industrials remains the slowdown in the Chinese credit impulse. However, the upbeat picture for DM capex and inventory growth counters this negative side. We continue to recommend some hedges against this risk. When it comes to our Sweden overweight, we still advise selling Norway, a position that has worked out well. We also still like selling consumer discretionary equities / long European telecoms to protect portfolios against a greater-than-anticipated global slowdown. Bottom Line: Global safe-haven yields are unlikely to decline significantly from current levels. Instead, they will rise meaningfully in the coming quarters, even in Germany. Consequently, investors with an investment horizon greater than six months should curtail their portfolio duration once again. Higher yields will also benefit European bank equities. We also recommend investors buy European momentum stocks and sell growth stocks. Finally, European industrials are set to shine compared to the rest of the European market, which will give a fillip to Swedish stocks, our favored European market.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Currency Performance Currency Performance The Ageing Bond Rally The Ageing Bond Rally Fixed Income Performance Government Bonds The Ageing Bond Rally The Ageing Bond Rally Corporate Bonds The Ageing Bond Rally The Ageing Bond Rally Equity Performance Major Stock Indices The Ageing Bond Rally The Ageing Bond Rally Geographic Performance The Ageing Bond Rally The Ageing Bond Rally Sector Performance The Ageing Bond Rally The Ageing Bond Rally

Highlights Economy – The Fed remains unperturbed about inflation, even as it continues to surprise to the upside: At his latest press conference, Chair Powell repeated the mantra that the spike in inflation will prove to be temporary. The shape of the inflation expectations curve supports the Fed’s view and the key expectations boxes of our inflation checklist remain unchecked. Markets – The decline in Treasury yields indicates that investors aren’t too worried about it, either: Although inflation data have continued to surprise to the upside, investors and the broader public seem to have moved on after the release of the March and April numbers. Inflation agita is not gone for good, but it may remain dormant until the fall. Strategy – The economic and policy backdrops remain favorable for risk assets and we remain overweight equities and spread product: Stop us if you’ve heard this one before, but risk assets will continue to generate positive excess returns over Treasuries and cash unless the Delta variant disrupts activity. Feature What a difference ten weeks make. When we rolled out our checklist on May 24th, inflation was Topic A for BCA clients and Google searchers, but it has been coming up less in our meetings and the internet queries are half of what they were (Chart 1). Inflation is a critical element of bond and currency markets, however, and it can have significant implications when it diverges from market expectations. Its currently elevated level and the novelty and uncertainty of the Fed’s revised approach to it ensure that it will intermittently command the spotlight. Chart 1Oh, Never Mind Oh, Never Mind Oh, Never Mind Down the road, we think it has a good chance to break above a range that investors and policymakers are comfortable with, and we will review our inflation checklist every month or two to keep clients apprised of its course. We have checked the same three boxes that we did six weeks ago and the story from the charts underlying them is unchanged. Inflation remains well above 2% year-over-year and it will stay there for the foreseeable future. The Fed is nowhere close to deploying its tools to guide it back down to its stated target, however, so it presents no danger to the potent post-pandemic expansion, and households’ and businesses’ mindsets do not appear to have changed in any way that would presage a self-reinforcing dynamic that would feed an inflation spiral. If inflation isn’t going to become problematic any time soon, overheating is not a pressing risk over our twelve-month investment timeframe. If we are correct that the new Delta-powered wave of COVID infections will not strain the health care system’s capacity or spark an unsettling pickup in fatalities, we won’t need to increase our probability of a growth shortfall. From an investment strategy perspective, diminishing probabilities of too-hot and too-cold tail outcomes support continued risk-friendly positioning. The Goldilocks outcome of strong growth backed by ultra-accommodative monetary policy should allow risk assets to continue generating positive excess returns over Treasuries and cash over the next twelve months. Updating The Inflation Checklist Table 1Inflation Checklist Resolute Resolute As mentioned above, we have checked the same three boxes on our inflation checklist that we did in late May and late June (Table 1). The labor market story remains unchanged: employer demand is at all-time highs as measured by the Job Openings components of the NFIB and JOLTS surveys (Chart 2). Labor supply has not risen to meet it, however, as a range of factors, including reduced caregiver availability (for children and adults), reluctance to risk infection and generous unemployment insurance benefits, converge to limit the number of job seekers. Though record demand and limited supply would be expected to lead to much higher prices, wage growth has remained contained (Chart 3), especially in the more refined series that adjust for composition effects or include benefits (Chart 3, bottom two panels). Chart 2Help Wanted Help Wanted Help Wanted Chart 3Wage Growth Has Remained In Check Wage Growth Has Remained In Check Wage Growth Has Remained In Check Year-over-year increases in core CPI and the core PCE price index have continued to accelerate (Chart 4, solid lines). They seem to have lost their ability to shock after April, however, as inflation expectations have taken little note of them and Google “inflation” searches have come off the boil. Investors apparently accept the Fed’s contention that the base inflation readings are being distorted by price moves in spaces that have been especially impacted by the pandemic and subsequent component shortages. Though the Fed's explanation may seem awfully convenient, its read is supported by the much more modest moves in the trimmed-mean CPI and PCE indexes (Chart 4, dashed lines). Chart 4Inflation Is Not Quite As Bad As It May Seem ... Inflation Is Not Quite As Bad As It May Seem ... Inflation Is Not Quite As Bad As It May Seem ... We continue to check the inflation pipeline box as our Pipeline Inflation Pressure Index is still pointing steeply higher (Chart 5). With components like the CRB’s Raw Industrials Index showing no sign of letting up, pipeline pressures will not just go away. The dollar’s recovery is limiting inflation pressure from the import channel, though inflation is comparatively muted in both the euro zone (Chart 6, top panel) and China (Chart 6, bottom panel) in any event. Chart 5... But Its Got Legs ... But Its Got Legs ... But Its Got Legs Chart 6Global Pressures Are Mild For Now Global Pressures Are Mild For Now Global Pressures Are Mild For Now Chart 7Markets Are Looking Through Temporary Inflation Pressures ... Markets Are Looking Through Temporary Inflation Pressures ... Markets Are Looking Through Temporary Inflation Pressures ... Chart 8... And So Are Consumers ... And So Are Consumers ... And So Are Consumers We continue to view inflation expectations as the key to a meaningful inflection. If households, businesses and investors begin to anticipate a much higher rate of inflation over the longer term, they will change their behavior in ways that will cause their expectations to become self-fulfilling. We are therefore especially focused on the inflation expectations curve and have been relieved to see that market measures (Chart 7) and surveys (Chart 8) indicate that investors and other economic participants believe that an elevated rate of consumer price increases will not persist beyond the next year or two. As Table 2 illustrates, the inverted TIPS and CPI swaps expectations curves project a significant decline in inflation from the near term to the intermediate and long term. Table 2The Inflation Expectations Curve Is Solidly Inverted Resolute Resolute The Fed Stays The Course The FOMC meeting and Chair Powell’s subsequent press conference were thin gruel, as the committee neither made nor telegraphed any meaningful course changes. Our main takeaway from the press conference was that the Fed is in no hurry to remove monetary accommodation because it is unperturbed by the inflation data that have come out over the last several months. As for accommodation, tapering is first on the agenda, but it doesn’t look like Powell will tackle the issue at Jackson Hole later this month: “We have not reached substantial further progress yet. So we’re not there, and … we see ourselves as having some ground to cover to get there.” Following the meeting, market consensus coalesced around a November or December announcement preceding a reduction in purchases beginning in January. Powell continued to stick to his ongoing inflation story, arguing that elevated inflation prints have resulted from idiosyncratic disruptions or base effects in segments that have been particularly affected by the pandemic. “What we’re seeing is a handful of things that really account for the overshoot of inflation. … [N]ew, used and rental cars have moved up in price because of the car shortage because of the semiconductor shortage. And hotels and airfares have moved back up, but that really just is retracing the very large downward movement in prices that they had before (Chart 9). [T]hat’s a big, big part of why the inflation readings are so high. And those frankly don’t carry significant implications in the long run for inflation or for the American economy.” Chart 9Inflation Isnt So Bad On A Two-Year Basis Inflation Isnt So Bad On A Two-Year Basis Inflation Isnt So Bad On A Two-Year Basis Powell also riffed on the meaning of “transitory” in response to a reporter’s question, offering some further insight into the Fed’s inflation perspective. “[W]hat I mean by transitory is just something that doesn’t leave a permanent mark on the inflation process. I don’t mean that producers are going to take those price increases back. That’s not the idea. It’s just that they won’t go on indefinitely. So to the extent people are implementing price increases because raw materials are going up or labor costs or something’s going up, you know, the question for inflation really is, does that mean they’re going to go up the next year by the same amount?” Yet Another Great Quarter For Earnings Chart 10Following The New Script To A T Resolute Resolute Last week, with 25% of S&P 500 constituents having reported results, we noted that 2Q21 was shaping up to be the index’s fifth consecutive quarter of dramatically outsized earnings beats. Now that 60% of the S&P has reported, including all five of the mega-cap FAAMG companies, we can declare that the streak will reach five when this reporting season is complete. Once again, knockout results (Chart 10, bottom panel) have stood the long-established guide-down-a-little-before-reporting-then-beat-by-a-modest-margin pattern (Chart 10, top panel) on its head. This quarter’s beat, currently tracking to 13%, will join the previous four pandemic quarters’ beats in obliterating the 1-to-6% range that contained every single quarter from 2012 to 2019 (Chart 11). Chart 11The Monster Beats Continue Resolute Resolute The immediate upshot has been for the consensus second quarter earnings estimate to be revised higher to a level that surpasses first quarter earnings and our “easily attainable” $50 ballpark estimate (Table 3). If the Delta variant does not upend economic activity, as per our base case, we think there is scope for forward estimates to be revised higher. The current forecast has four-quarter earnings through 2Q22 ($204.70) barely rising from the current quarter’s annualized run rate ($203.84). That is unusual in a series that has a lifetime mean of 18% and rarely contracts, especially given that the economy is expanding at a gangbusters clip. Table 32Q21's Been Fixed, But The Out Quarters Still Have Scope To Rise Resolute Resolute Investment Implications Chart 12The Shelves Are Almost Bare The Shelves Are Almost Bare The Shelves Are Almost Bare We are undeterred by last week’s GDP disappointment, broader concerns about deceleration or overwrought talk about stagflation. 6.5% real second-quarter GDP growth came in well short of the consensus 8.4% expectation, but the number wasn’t as bad as it may have appeared to the naked eye. Real final domestic demand, which looks through inventory swings and net exports to provide a truer barometer of ongoing activity, grew at an 8.1% rate, powered by nearly 12% growth in consumption. The continued depletion of retail inventories, which must be restocked to meet ravenous consumer demand (Chart 12), pushed some growth into subsequent quarters, so growth may not have peaked in 2Q after all. As for stagflation, it simply doesn’t apply when the world’s largest economy is growing at the rate of a developing economy, three times its trend, over a year into an expansion. On balance, the new information we received last week was favorable. The Fed reiterated its resolve to keep supporting the economy with emergency levels of monetary accommodation even though the emergency has passed; S&P 500 earnings continue to shoot the lights out, forcing analysts into lifting their estimates once future quarters get closer; and consumers are spending with gusto, suggesting that excess pandemic savings and robust gains in household net worth will provide an ongoing lift to the economy well into 2022. All in all, the macroeconomic backdrop remains favorable for investors in risk assets and we continue to recommend overweighting them.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com  

Highlights The dollar is fighting a tug of war between two diverging forces: an economic slowdown around the world but plunging real interest rates in the US. The litmus test for determining which force will gain the upper hand is if the DXY fails to break above the 93-94 level that marked the March highs. So far that appears to be the case. In the interim, investors can capitalize on a few themes that will ultimately unfold: an end to the China slowdown, a bet on real rates staying low for longer, and a play on the Olympics. The expressions of these themes are long AUD/MXN, long silver and long the yen, respectively. Natural disasters are also rising in frequency globally. Historically, this has coincided with rising currency volatility. Long CHF/NZD positions can be a potent play on this trend. We ultimately expect the dollar lower 9-12 months from now. The best currencies to express this view today are NOK and SEK. Feature We are a month into the second half of year, and it is instructive to revisit the dollar view and our roadmap towards year-end. As a starting point, two key themes are propping the dollar on a tactical basis: The first is a global economic slowdown, one that could be exacerbated by increased infections of the COVID-19 Delta variant. The dollar tends to rise in an environment where global growth is weak. This is especially the case when US growth is relatively resilient, like now (Chart I-1). The second is the resilience of the US equity market, not only due to superior earnings, but also as regulatory crackdowns hit shares in China specifically, and emerging markets in general. Equity inflows into the US were a key reason the dollar did not collapse in 2020. Renewed inflows into US equities will be particularly beneficial for the dollar (Chart I-2). This will especially be the case if technology and healthcare earnings keep surprising to the upside. Chart I-1The Dollar And Relative Economic Momentum The Dollar And Relative Economic Momentum The Dollar And Relative Economic Momentum Chart I-2The US Is Leading The Earnings ##br##Cycle The US Is Leading The Earnings Cycle The US Is Leading The Earnings Cycle At the same time, real interest rates in the US are very depressed. In its latest meeting, the Federal Reserve reiterated that it will keep running the economy hot, a thesis central to our bearish dollar view. This puts the dollar in a tug of war between two diverging forces: an economic slowdown around the world but plunging real interest rates in the US. Arbitrating The Tug Of War Historically, unless the world economy experiences a recession, the interest rate story has dominated currency market action. Our report last week showed that real interest rates matter for currencies both short term and longer term. Given our bias that global growth will moderate rather than contract, the future path of interest rates will once again become important for currency market action. In this light, lower real rates are negative for the US dollar. How long the outperformance of US equities will last is a tougher call. What we do know is that in a rising interest rate environment, the US equity market has tended to derate relative to the rest of the world. Our base case is that bond yields will be higher globally on a cyclical horizon, suggesting investors should fade the current outperformance of US equities. Scandinavian Currencies As A Strategic Dollar Play The best currencies to express a cyclically lower dollar are the NOK and SEK, for a few reasons other than the strong correlation with the DXY index (Chart I-3): Chart I-3NOK And SEK Are A Play On DXY NOK and SEK Are A Play On DXY NOK and SEK Are A Play On DXY Economic momentum in both Norway and Sweden is picking up steam. In Norway, high oil prices will be a cyclical boost to the currency, as has been the case historically. Meanwhile, Sweden is benefiting from a strong manufacturing landscape, especially in autos where pricing has skyrocketed due to shortages. While the Swedish manufacturing PMI has moderated recently, it still sits at 65.8, the highest level since the mid-1990s. Both currencies remain very cheap according to our models. Our favored PPP model shows that NOK and SEK are trading at a discount of 20% and 17% respectively, amongst the cheapest in the G10 (Chart I-4). Chart I-4The Dollar Is Expensive Trade Themes Into Year End Trade Themes Into Year End Norway, Sweden and Canada are among the countries whose output gaps are expected to close relatively fast (Chart I-5). In the case of Norway (and Canada), the central bank has been vocal about curtailing monetary accommodation, as market conditions improve. The upside surprise in Swedish GDP this week lowers the odds of more monetary accommodation from the Riksbank. This will boost real rates in these countries, supporting their currencies. Chart I-5Output Gaps Across The G10 Trade Themes Into Year End Trade Themes Into Year End In a nutshell, if the dollar heads lower 9-12 months from now, this will benefit most procyclical currencies, with the NOK and SEK as winners. The Yen As An Olympian Chart I-6Currencies And The Olympics Trade Themes Into Year End Trade Themes Into Year End We made the case last month that the yen was the most underappreciated G10 currency, and that certainly remains true.  Since then, there has been improvement in the Japanese economy: The vaccination campaign is progressing smoothly, with 27% of the population having been inoculated from almost nil earlier this year. Meanwhile, about 38% have received at least one dose. This should curtail hospitalizations, despite the increase in new cases. Economic momentum remains tepid, but there are green shoots. Real cash earnings are inflecting higher, which is boosting household spending. There was also remarkable improvement in the Eco Watchers Survey, a sign of optimism among small and medium-sized businesses. Global trade remains strong, which is a boost to the Japanese external sector. While this may slow going forward, it will be a benign headwind. Japan is less exposed to China, a key market for exports, compared to its developed market peers like Australia and New Zealand. Meanwhile, China is already easing policy at the margin. The true catalyst for the yen could be the Olympics. Since the 1970s, the median performance of a currency hosting the Olympics is 4% over a year. The performance of the yen today falls well below the 25th percentile of this performance gap (Chart I-6). This year’s games have obviously been unique given the pandemic but given that the yen is the most shorted G10 currency, this is probably already in the price. It also it does raise the prospect that the yen rises from being an underdog to staging a powerful mean reversion rally. While Japan will not get a tourism boost this summer that will buffet discretionary spending, foreigners are likely to return as the pandemic is put behind us. It is remarkable that Japanese shares, even construction and material companies, that should have benefited from the leadup to the Olympics, have massively underperformed (Chart I-7). This suggests that at the margin, many investors have folded hands and sold Japanese equities indiscriminately. Chart I-7Japanese Shares Have Underperformed Japanese Shares Have Underperformed Japanese Shares Have Underperformed Finally, real rates in Japan are among the highest in the G10. This will not only prevent Japanese concerns from deploying yen cash on foreign paper, but could also lead to some repatriation of funds, boosting the yen. Low Real Rates: Buy Silver (And Platinum) The case for buying silver has become compelling, at least on a tactical basis. First, the runup in prices from under $12/oz in March to almost $30/oz in August ushered silver into a well-defined wedge formation, with a series of higher lows. We are now sitting close to the lower bound of this wedge. Given our expectation that any DXY rally will be capped at 93-94, this puts a solid floor under silver prices around the $22-$23/oz level (Chart I-8). This makes for an attractive risk/reward since silver could overtake its 2011 highs near $50/oz, once strong resistance at $30/oz is breached. Second, similar to gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for fiat money debasement. But unlike gold or even cryptocurrencies, physical use for silver is quite elevated. Silver fabrication demand benefits from electronic production (whereby there is a shortage, so it is bound to eventually increase), as well as new green industries such as solar power that are dominating the manufacturing landscape (Chart I-9). Meanwhile, our Commodity & Energy Strategists have flagged that the surplus of silver is expected to shrink significantly this year, driven by both industrial and investment demand (Chart I-10). Chart I-8Buy Some Silver Buy Some Silver Buy Some Silver Chart I-9Silver Demand Is Picking Up Trade Themes Into Year End Trade Themes Into Year End Chart I-10The Silver Surplus Is Shrinking Trade Themes Into Year End Trade Themes Into Year End Third, silver is also a more potent play on a lower dollar. This is because the silver market is thinner and more volatile, with futures open interest at about one-third that of gold. Put another way, volatility in silver has always been historically higher than gold, which is why silver tends to outperform gold when the dollar is falling (Chart I-11). Chart I-11Silver Is A More Potent Play On The Dollar Silver Is A More Potent Play On The Dollar Silver Is A More Potent Play On The Dollar It is worth pointing out that the velocity of money between the US and China is slowing again, suggesting growth is likely to start outperforming outside the US, beyond the current slowdown. The US benefits less from a pickup in Chinese growth, compared to other countries. This has generally pushed the dollar lower and set fire under the silver/gold ratio (Chart I-12). Finally, there is also a case to be made for platinum. It has lagged both gold and palladium prices (Chart I-13). Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart I-12Money Velocity And The GSR Money Velocity And The GSR Money Velocity And The GSR Chart I-13Platinum And Silver Have Lagged Gold Platinum And Silver Have Lagged Gold Platinum And Silver Have Lagged Gold China Slowdown Almost Over: Buy AUD/MXN Soon We highlighted in February that a tactical opportunity had opened to go short the AUD/MXN cross. With the cross down 11% from its recent highs, an opportunity to go long will soon open up. China has started easing policy at the margin. The AUD/MXN cross correlates quite strongly with the Chinese credit cycle, as Australia is economically tied to China while Mexico depends more on the US (Chart I-14). The Australian PMI has remained quite firm, despite a slowdown in the Chinese credit impulse. Strong commodity prices have been a factor, but it also points to endogenous strength in the Aussie economy. Relative terms of trade favor the Aussie. We had expected terms of trade between Australia and Mexico to relapse on the basis of destocking in China, but that has not been the case (Chart I-15). With oil prices structurally challenged by EVs, while metal prices benefit from the buildout of green infrastructure, terms of trade will remain favorable for the cross longer term. Australian stocks have been underperforming the more defensive Mexican bourse (Chart I-16). This should reverse as cyclicals start to regain the upper hand. Chart I-14AUD/MXN Tracks Chinese Credit AUD/MXN Tracks Chinese Credit AUD/MXN Tracks Chinese Credit Chart I-15AUD/MXN And Terms Of Trade AUD/MXN And Terms Of Trade AUD/MXN And Terms Of Trade Chart I-16AUD/MXN And Relative Equity Prices AUD/MXN And Relative Equity Prices AUD/MXN And Relative Equity Prices The timing for a long position is tricky as Chinese economic activity is likely to slow in the coming months, and cyclical equities could remain under pressure. Meanwhile, as value investors, we are also uncomfortable with AUD/MXN valuations. This suggests that in the very near term, short positions still make sense. That said, the 13-14 zone should provide formidable support to go long, an opportunity likely to unfold in the next 3 months (Chart 17).  Chart I-17AUD/MXN And Momentum AUD/MXN And Momentum AUD/MXN And Momentum A Final Thought On Rising Catastrophes We have been watching with obvious trepidation the rising incidence of catastrophes globally. The occurrence of weather events such as droughts, floods, storms, cyclones, and wildfires has been skyrocketing (Chart I-18). Chart I-18Disasters And Volatility Trade Themes Into Year End Trade Themes Into Year End The direct play is to buy global construction and machinery stocks that are likely to benefit from increased reconstruction activity. It also favors agricultural futures. As for currency markets, the one observation is rising volatility with the VIX having spiked significantly in the years with numerous weather events.  We are already long CHF/NZD and the yen as a play on rising currency volatility, and we will be exploring this thesis more deeply in future publications.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was relatively robust: The Markit manufacturing PMI for July edged up from 62.1 to 63.1. That said, the services PMI fell from 64.6 to 59.8. Durable goods orders were rather weak, rising 0.8% year on year in June, versus a consensus of a 2.2% increase. Admittedly, the core non-defense measure, excluding aircraft and parts, rose by 0.5% from 0.1%. Consumer confidence remains resilient, rising from 127.3 to 129.1 in July, well above expectations. Q2 GDP came in at 6.5% quarter on quarter, versus an 8.4% consensus. The US dollar DXY index fell this week. The Fed meeting highlighted that the authorities are in no rush to tighten monetary policy, despite what has been a robust recovery in labor market conditions and inflation. The aftermath of the meeting saw a drop in US real yields and the dollar. The Fed’s dovish stance has been a central theme to our bearish dollar view. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of the eurozone this week softened: The manufacturing PMI fell to 62.6 in July from 63.4. The services PMI surprisingly improved, rising from 58.3 to 60.4 in July. Economic confidence rose from 117.9 to 119 in July. The German IFO survey was below consensus in July, but the expectations component did rise from 99.6 to 100.4. The euro rose by 1% this week. We went long the euro at 1.18 on expectations that at the margin, monetary policy in the euro area will shift in a more hawkish fashion. Since then, the ECB has adopted a symmetric inflation target, promising to keep interest rates low for longer. The euro’s indifference to this dovish development suggests a strong floor under the currency, and upside should euro area growth beat consensus. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data was rather mixed this week: The Jibun manufacturing PMI eased slightly in July, to 52.2 from 52.4. The services component also fell to 46.4. Department store sales came in at 3.7% year on year in June. We highlighted last week that supermarket sales also remain strong. The yen was up 0.4% against the dollar this week. In the history of the Olympics, the incumbent currency has tended to rise over the course of the year. Given the yen is the most shorted developed-market currency currently, this sets it up for a coiled spring rebound. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There were some mixed data out of the UK this week: Retail sales in the UK were in line with expectations. The measure excluding automobiles and fuel rose by 7.4% year on year in June. The PMIs generally slowed from very strong levels. The manufacturing print for July was 60.4, while the services component came in at 57.8. House price inflation remains strong, with the nationwide measure coming in at 10.5% year on year in July. Mortgage approvals fell slightly in June but remain at a robust 81.3K. The pound rose by 1.5% this week. The big surprise in the UK has been a reversal in the COVID-19 infection rate, despite an economy that is reopening quite briskly. This sets cable up for a volatile few weeks and months, given a poor technical picture (speculations are cutting long positions from very aggressive levels). We like GBP long term but will stand aside for now. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The inflation report in Australia was in line with expectations for Q2: Headline CPI rose from 1.1% to 3.8%. The trimmed mean and median measure came in at 1.6% and 1.7% respectively. The AUD was flat this week, the worst performing G10 currency. The dominant story remains the renewed restrictions from a resurgence in COVID-19, particularly in Sydney. That said, weakness in AUD is starting to create an attractive reward/risk profile. Speculators are net short the Australian dollar, and our bias is that there has been spillover pressure from the recent turmoil in Asian/Chinese markets. In the end, this only makes for a coiled spring rebound in the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: The trade balance came in at NZ$261 million, even with stronger imports in June. The ANZ activity outlook index fell in July, to 26.3 from 31.6. The NZD was up 0.5% this week. The strong rally in NZD after a hawkish RBNZ a fortnight ago continues to fade. This week, we highlighted a new theme, which is the rising incidence of natural disasters. Historically, this has been great for agricultural prices, benefiting NZD. But it has also been accompanied by a tremendous rise in currency volatility, which hurts the NZD vis-à-vis safe-haven currencies. We are currently long CHF/NZD and will be exploring this theme in future publications. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been mixed: Retail sales fell month on month in May by 2.1% but this was above expectations. Inflation remains robust. Headline CPI was 3.1%, while the core trim, median and common measures came in at 2.6%, 2.4% and 1.7% respectively. The CAD rose by 0.8% this week. The backdrop for the loonie remains positive as the Bank of Canada is leaning against monetary accommodation by tapering asset purchases, and signaling interest rate increases, while the Fed remains on hold. These pin real interest rate differentials in favor of the loonie. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Investor confidence from the Credit Suisse survey fell in July, from 51.3 to 42.8. Total sight deposits were unchanged at CHF 712 bn for the week of July 23. The Swiss franc was up 1.3% this week. Incoming Swiss inflation data next week will dictate whether the SNB steps up the pace of FX intervention. So far, there have been no big moves in the CHF exchange rate to implore central bank attention. A rebound in global bond yields will be a welcome relief since the franc tends to weaken in that environment. For the time being, we believe volatility can continue to rise. As such, the franc will benefit, justifying long CHF/NZD bets. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: Retail sales were flat month on month in June. The NOK was up 1% this week. Our limit buy on Scandinavian currencies was triggered a fortnight ago, nudging us in the money with this week’s currency moves. We are not fighting the Norges Bank, which has signaled they will increase interest rates this year, ahead of both the Federal Reserve and the ECB. As such, we are short EUR/NOK and USD/NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been improving: The PPI for July came in at 9.6%, up from 7.9%. The June trade balance showed a healthy surplus of SEK 10.3 billion. The economic tendency survey for July came in at 122.4 from 119.8. Manufacturing confidence continues to inflect higher, rising from 125.2 to 129.2 in July. The SEK was the strongest performing G10 currency this week, rising 1.5%. Swedish Q2 GDP was a welcome positive surprise, up by 10.5% year on year and 0.9% quarter on quarter. This is paring back expectations of more stimulus from the Riksbank. We have been highlighting that SEK remains one of our most potent plays on a global growth recovery. As such, we are short EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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