Sectors
Highlights The ECB has changed its inflation target, but its credibility remains weak. Inflation will not allow the ECB to tighten policy anytime soon. Instead, the ECB will have to add to its asset purchase program next year and may even consider dual interest rates. EUR/USD should continue to appreciate because of the weakness in the USD, but EUR/GBP, EUR/NOK, and EUR/SEK will soften. The SNB will follow the ECB; buy Swiss stocks / sell Eurozone defensives as an uncorrelated trade. China matters more than COVID-19 for the cyclical/defensive ratio. Despite our pro-cyclical medium- to long-term portfolio bias, the reflation trade is pausing. Remain tactically long telecom / short consumer discretionary as a hedge. European momentum stocks are near critical levels relative to growth equities. Feature The European Central Bank has found a new way to shed its Bundesbank heritage further and to justify the continuation of its QE program well after other central banks around the world will have ended their asset purchases. The early results of the Strategy Review and the subsequent comments by President Christine Lagarde will make it near impossible for the ECB to taper its asset purchases anytime soon. Practically, this means that the European yield curve will steepen relative to that of the US. Additionally, this policy should not hurt EUR/USD, but it will hurt EUR/GBP, EUR/NOK, and EUR/SEK. In the equity space, Swiss stocks will outperform European defensive equities, creating an opportunity for an uncorrelated trade. A New Tougher Target The ECB has abandoned its long-standing target of “close but below” 2% inflation. Even more importantly, the ECB followed the Bank of Japan and the Fed in adopting an approach whereby both downside and upside deviations from the 2% inflation target are to be fought. The ECB’s credibility was already hurt by its inability to achieve its more modest previous inflation target. Since 2009, the Euro Area HICP only averaged 1.2% (Chart 1). To prevent losing further credibility under its new mandate, the ECB will have to increase its stockpile of assets. Moreover, the ECB is far from achieving its new mandate, which will add to the ECB’s need to expand stimulus to the system even once the impact of owner-equivalent rent is included in CPI. Chart 1Mission Impossible Chart 2Narrow Inflationary Pressures Today, the ECB’s measure of core inflation stands at 1%, while headline inflation is 1.9%. As the economy re-opens, a surge in inflation is likely, but this spike will be transitory, even more so than in the US. As we recently showed, our estimate of the Eurozone trimmed-mean CPI has plunged close to 0%, which highlights that inflation pressures remain narrow (Chart 2). The labor market is another hurdle that will prevent Eurozone inflation from durably reaching 2% anytime soon. Currently, the total hours worked in the Euro Area remains well below the equilibrium level implied by the working-age population (Chart 3), which historically constrains wages. Moreover, it generally takes many quarters after labor shortages become prevalent before inflation begins to inch higher (Chart 4). Chart 3No Wage Pressure Yet Chart 4No Inflation Labor Shortages For A While The euro is the last force that caps European inflation. Despite the recent depreciation in EUR/USD, the trade-weighted euro remains near all-time highs, which historically imparts strong deflationary pressures to the economy (Chart 5). Beyond the time it will take for realized inflation to reach the ECB’s new target, inflation expectations are still inconsistent with 2% inflation. As the top panel of Chart 6illustrates, market-based inflation expectations in the Eurozone remain well below both 2% and the levels that prevailed before the Great Financial Crisis, even though rising commodity prices are lifting global inflation expectations. Market participants are not alone in doubting the ECB; professional forecasters do not see inflation at 2% in the near-term or the long-term (Chart 6, bottom panel). Chart 5The Euro Is Deflationary Chart 6The ECB Lacks Credibility In addition to the continued inability of the ECB to achieve its previous inflation target, let alone its present one, sovereign risk still hamstrings the central bank. The Italian economy remains fragile, because little structural reform has taken place. The Spanish economy cannot stand on its own two feet while the tourism industry continues to suffer due to COVID-19 related fears. And the exploding debt load of the French economy as well as its structural current account deficit raise the possibility that OATs will become unmoored. The ECB will ensure that spreads in those nations do not widen, or Eurozone inflation will never reach the new 2% target. Bottom Line: When it was time to achieve near—but below—2% inflation, the credibility of the ECB was already limited. The new target will be even harder to reach, but the symmetry around it gives the ECB more leeway to provide additional support to the Eurozone economy. Market Implications The ECB is now bound to maintain policy accommodation beyond the scheduled end of the PEPP program in March 2022, or the new policy target will be even less credible than the previous one. BCA Global Fixed Income Strategy team expects the ECB to maintain its asset purchase program beyond the stated end of the PEPP. Practically, this means that the ECB will fold the program into the pre-pandemic APP. The ECB cannot tighten policy while it remains so far from its target, especially now that missing the goalpost to the downside is as problematic as missing it to the upside. We expect the ECB to hint at this on Thursday. Chart 7The EONIA Curve Anticipated The Strategy Review The ECB will also not increase interest rates for the foreseeable future, which the EONIA curve already anticipates (Chart 7). Money markets only expect a first hike in late 2024, which is appropriate. Compared to a month ago, overnight rates 10-year forward fell by more than 10bps, from 0.75% to 0.61%. We are inclined to fade this move. More stimulus raises the outlook for long-term policy rates. Amid the correction in global bond yields, betting against the decline in the long-term EONIA rate is akin to catching a falling knife; however, because the ECB is easing relative to the Fed, a box trade of buying European steepeners at the same time as US flatteners remains appropriate. The ECB could also lower the rate on TLTRO operations, resulting in a dual interest rate regime in the Eurozone. As Megan Greene and Eric Lonergan have argued, this policy would provide a further lift to the Euro Area economy by boosting the attractiveness of borrowing; at the same time, it would limit the deleterious impact of ever-more negative deposit rates on the profitability of the banking sector, because banks would borrow at extremely negative rates to finance lending activities. Chart 8JPY And YCC The effect of the policy on the euro is more complex. When Japan announced its Yield Curve Control strategy in September 2016, it defined price stability as achieving a 2% inflation rate over the span of the business cycle. In other words, the BoJ implemented a backdoor average inflation mandate. Following this announcement, USD/JPY strengthened (Chart 8), but this move reflected the dollar rally and the global bond selloff around the US election, not yen-specific factors. This suggests that the euro will continue to track the USD inversely. BCA’s FX Strategy team remains bearish on the greenback, as a result of the growing US current account deficit and the fact that the Fed continues to target an overshoot in inflation, which suggests that, even if US nominal interest rates rise, real rates will lag behind. The EUR is nonetheless set to underperform compared to other European currencies. In the UK, house price gains are accelerating, the jobless count is declining rapidly as the economy re-opens, and the cheapness of the pound is accentuating positive inflation surprises. This combination suggests that the BoE is likely to follow the path of the Bank of Canada or the Reserve Bank of New Zealand, by beginning to tighten policy by early next year. Norway also faces a similar set of circumstances and has already announced it will lift interest rates this year. As we argued two months ago, the Riksbank is likely to follow its western neighbor, because the Swedish housing market is roaring, and the economy will remain well supported by the upcoming global capex boom. Hence, EUR/GBP, EUR/NOK, and EUR/SEK will depreciate. The Swiss National Bank should be the outlier that will follow the ECB. Swiss headline and core inflation linger at 0.6% and 0.4%, respectively. Wage growth is a meager 0.5%, because the Swiss output gap remains a massive 5.5% of GDP (Chart 9, top panel). Meanwhile, consumer confidence and retail sales are much weaker than those of Sweden, Norway, or the UK. Finally, Swiss private debt stands at 270% of GDP, which means that this economy still risks falling into a Fisherian debt-deflation trap. As a result, the SNB will continue to try to cap the upside in the CHF vis-à-vis the EUR, because the currency remains the main determinant of Swiss monetary conditions. Moreover, according to the central bank, the Swiss franc is still 10% overvalued relative to the euro, which is weighing on the country’s competitiveness (Chart 9, bottom panel). To fight the recent depreciation of EUR/CHF, the SNB will not raise rates for a long time and will intervene further in the FX market. The liquidity injections should prompt additional increases in the SNB’s domestic sight deposits, which since 2015 have resulted in a rise of Swiss bond yields relative to those of Germany (Chart 10). While counterintuitive, this relationship reflects the reflationary impact of the SNB’s asset purchases. It also means that the Swiss real estate market is set to become ever bubblier. Chart 9The SNB Will Follow The ECB Chart 10Swiss/German Spreads To Widen For Swiss shares, the picture is more complex. Swiss equities are extremely defensive, but, while they underperform Euro Area stocks when global yields rise, widening Swiss / German spreads often provide a lift to the SMI. A simple model, assuming US 10-year Treasury yields rise to 2.25% by the end of 2022 (BCA’s US Bond Strategy forecast) and that Swiss/German spreads widen to 20bps as the SNB domestic sight deposits swell, suggests that Swiss stocks will underperform that of the Euro Area over the coming 18 months (Chart 11). However, if we compare Swiss equities to European defensive sectors, then the widening in Swiss/German spreads should prompt an outperformance of Swiss equities, because their multiples benefit from ample liquidity conditions in Switzerland (Chart 12). Chart 11Swiss Stocks Are Too Defensive To Outperform Durably... Chart 12...But They Will Beat Euro Area Defensives Bottom Line: The results of the ECB Strategy Review will force this central bank to remain a laggard and continue to expand its balance sheet well after the expected end of the PEPP program. Eurozone interest rates will also fall behind that of other major economies. The ECB may even consider cutting the interest rate on TLTROs to boost lending. These policies will have a minimal impact on EUR/USD, which will continue to be dominated by the dollar’s fluctuations. However, EUR/GBP, EUR/SEK, and EUR/NOK will suffer. Finally, the SNB will follow the ECB and expand its balance sheet further, which will paradoxically lift Swiss/German spreads. As a result of their defensive nature, Swiss stocks will underperform Euro Area ones over the next 18 months, but they will outperform European defensive equities. Go long Swiss equities relative to European defensives, as a trade uncorrelated to the broad market. Follow China, Not Delta Chart 13 In recent days, doubts have grown about the European re-opening trade because of the resurgence of COVID-19 cases. The Delta variant (or any subsequent mutation for that matter) will cause hiccups along the way, but, ultimately, the re-opening will continue to proceed. As a result of the growing rate of vaccination, hospitalizations and deaths remain stable even if new cases are climbing rapidly in many countries (Chart 13). As long as the burden on the healthcare system remains limited, governments will find it difficult to justify further large-scale lockdowns. Instead, measures such as Macron’s Pass Sanitaire will provide increasing, widespread incentives for greater vaccination. Despite this sanguine take on the Delta variant, we remain concerned for the near-term outlook for cyclical equities because of the Chinese economy, even after the recent 50bps cut in the Reserve Requirement Ratio. BCA’s China Investment Strategy service believes that the RRR cut does not signal the beginning of a policy easing cycle. More evidence would be needed, such as additional RRR cuts, rising excess reserves, or supportive policies for the infrastructure and real estate sectors. For now, we heed the message from PBoC official Sun Guofeng that “the RRR cut is a standard liquidity operation.” Chart 14Fade The RRR Cut The dominant force for the Chinese economy remains the previous deterioration in the credit impulse, which suggests that Q3 and Q4 growth will decelerate materially (Chart 14, top panel). Moreover, the softening impulse is consistent with weaker global economic activity, as approximated by our Global Nowcast (Chart 14, middle panel), especially since the lingering effect of the past RRR increases is still consistent with a global deceleration (Chart 14, bottom panel). In this context, we continue to hedge our long-term preference for cyclical stocks because of the near-term risks created by China and the excessively rapid move in the cyclical-to-defensives ratio (Chart 15). In response to this pause in the reflation trade, we continue to favor a long telecom/short consumer discretionary tactical position, which is supported by valuations and RoE differentials, as well as the still extended relative momentum (Chart 16). The period of risk to the global reflation trade should also allow the dollar to remain firm in the near-term, which means that for the coming months, the euro will not go beyond its trading range in place since the beginning of the year. Chart 15Cyclicals Remain Tactically Vulnerable Chart 16Stay Long Telecom / Short Consumer Discretionary Bottom Line: China’s RRR cut is not yet enough to bet against the temporary pause in the global reflation trade. Thus, investors should continue to hedge pro-cyclical long-term bets in their portfolios via a long telecom / short consumer discretionary position. An Exciting Chart A chart caught our eye this week: The underperformance of Eurozone momentum stocks relative to growth stocks is massively overdone (Chart 17). For now, we only want to highlight the phenomenon, but, in the coming weeks, we will delve deeper into the topic to gauge if these oversold conditions constitute an attractive opportunity. Chart 17Washed Out Moment Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance
In yesterday’s Sector Insight report we stripped out the base effect from SPX earnings growth. Today, we repeat this exercise and look at a two-year annualised growth rate for US headline CPI as well as some of its categories. Using 2019 as a benchmark year reveals that the headline number is at 3%, sitting on par with the 2011 level – a sharp contrast to the regular 12-month YoY CPI rate (6%) that is close to pre-GFC highs. In fact, the key food & energy categories also appear contained despite the former perking up during the pandemic (Chart 1). 2021/2020 comparison of food and energy prices yields 2.4% and 7.5% YoY inflation respectively. There are also exceptions: The used cars category is clearly accelerating (19%) even compared to 2019, albeit it is just a small component of the headline CPI number. For completion purposes, Chart 2 on the next page also shows data for some of the pandemic-scared industries including airlines and shelter, for which prices are still below pre-pandemic highs. Bottom Line: While optically the 2021 US inflation is surging, our analysis suggests that numbers are exaggerated by the base effect from the pandemic. Chart 1 Chart 2
Earnings season is upon us again. Time just flies! This quarter, according to Refinitiv, Net Income is expected to increase by 64.9% YoY on Revenue growth of 18.5%. EPS growth is expected to be 68.1% - it is higher than income growth by 3.2% thanks to the projected share repurchases. BCA Model expects a 3.6% buyback yield. These numbers are truly spectacular, and yet a little suspicious. So what do we make of them? Similar to the inflation story, Q2-21 earnings season growth numbers look so high because they are dominated by the base effect: growth is computed against the worst quarter of the pandemic, Q2-20. To strip out the base effect, we calculated quarterly earnings growth with respect to Q2 of 2019 for the S&P 500 as well as its GICS1 sectors. Looking at the cleaner numbers reveals that SPX quarterly EPS growth sits at a respectable 12.2%. This number appears manageable, in sharp contrast to eyewatering growth calculated based on Q2-20 comparables. Bottom Line: The implication is that once we take out the once in a lifetime pandemic effect, we observe that earnings growth is normalizing, and expectations are rather reasonable.
Feature Since the end of the first quarter, the decline in Treasury yields has been the most important trend in global financial markets. It has contributed to the return of the outperformance of growth stocks relative to value stocks, the underperformance of Eurozone equities relative to the S&P 500, and the tepid results of cyclicals relative to defensive equities. This decline in yields is a temporary phenomenon, because the global economy continues to re-open and inventory levels remain so low that further restocking is in the cards. The cyclical picture is not without blemish; COVID-19 variants remain a concern. However, if these risks were to materialize into another delayed re-opening, then further reflationary efforts by both monetary and fiscal authorities would buoy financial markets. The greatest near-term worry for the global economy and markets comes from China. The Chinese credit impulse is slowing markedly and fiscal support has yet to come to the rescue. This phenomenon is the main reason why this publication maintains a cautious tactical stance on Eurozone cyclical stocks, even if we believe these sectors have ample scope to outperform over the remainder of the business cycle. As a corollary, we believe that yields will likely remain within range this summer and Eurozone benchmarks will lag behind the US. This week, we review key charts, organized by theme, highlighting some of these key concepts. As an aside, none covers inflation. Even if the balance of evidence suggests that any sharp increase in Eurozone inflation will be temporary, the proof will only become more visible by early 2022. The Opening Is On Track… The pace of vaccination across the major Eurozone economies has picked up meaningfully since the spring. Consequently, the number of doses distributed per capita is rapidly approaching that of the US, even as it still lags behind that of the UK (Chart 1). As a result of this improvement, the stringency of lockdown measures is declining, which is allowing European mobility to recover (Chart 2). While this phenomenon is evident around the world, EM still lag in terms of vaccination rates. However, the Global Health Innovation Center at Duke University expects 10 billion vaccine doses to be produced by the year’s end, which will be enough to inoculate most (if not all) the vulnerable people in the world by early 2022. Consequently, the re-opening of the economy will remain a potent tailwind behind global growth for three or four more quarters. Chart 1Vaccination Progress... Chart 2...Leads To Greater Activity … But Near-Term Headwinds Remain The re-opening of the global economy will allow growth to stay well above trend for the upcoming 12 months, at least. Global industrial activity could nonetheless decelerate this summer. Input costs have risen. The two most important ones, oil and interest rates, are already consistent with a peak in the US ISM manufacturing and the global PMI (Chart 3). In this context, the decelerating Chinese credit impulse is concerning (Chart 4) because it portends a hit to global trade and industrial activity. The effect of this slowdown should be most evident in the third and fourth quarters of 2021. However, it will be temporary because Beijing only wants credit to grow in line with GDP, rather than an outright deleveraging. Thus, the credit impulse will stabilize before the year’s end, which will allow the positive effect of the global re-opening to be fully experienced once again. Chart 3Rising Input Costs... Chart 4...And China's Credit Slowdown Matter Domestic Tailwind In Europe Despite the extreme sensitivity of the European economy to the global business cycle, Europe should continue to produce positive surprises. The supports to the domestic economy are strong. The NGEU funds means that Europe will suffer one of the smallest fiscal drag among G-10 nations next year. Moreover, the re-opening will support household income and allow the positive effect of the increase in the money supply to buoy consumption (Chart 5). Finally, rising consumer confidence, and the ebbing propensity to save will reinforce the tailwinds behind consumption (Chart 6). Chart 5Europe's Domestic Activity Chart 6...Will Improve Further Higher Bond Yields Are Coming… The environment continues to support higher yields. Our BCA Pipeline Inflation Indicator is surging, which historically translates into higher global borrowing costs (Chart 7). Most importantly, our Nominal Cyclical Spending Proxy remains very robust, which normally leads to rising yields (Chart 8). While US inflation expectations at the short end of the curve already fully reflect current inflationary pressures, the 5-year/5-year forward inflation breakeven rates will have additional upside. Moreover, the term premium and real rates remain depressed, and policy normalization will cause these variables to climb higher over time. Chart 7Higher Yields Will Come... Chart 8...Later This Year … But Not This Summer It could take some time before the bearish backdrop for bonds results in higher bond yields. First, bonds have yet to purge fully their oversold status created by the 125 basis-point surge that took place between August 2020 and March 2021 (Chart 9). This vulnerability is even more salient in an environment in which the Chinese credit impulse is decelerating. As Chart 10 illustrates, a slowing total social financing number reliably leads to bond rallies. While the chart looks dire for bond bears, it must be placed in context, in which global fiscal policy remains accommodative considering the decline in the private sector savings rate and in which Advanced Economies’ capex will stay strong. Thus, instead of betting on a large swoon in yields in the coming quarters, we expect US yields to remain stuck between 1.20% and 1.70% for a few more months before they resume their upward path once the Chinese economy stabilizes. Chart 9But Bonds Are Still Oversold... Chart 10...And Fundamentals Cap Yields For Now A Positive Cyclical Backdrop For The Euro The near-term forces suggest that the euro will remain range bound over the summer, between 1.16 and 1.23. EUR/USD is a pro-cyclical pair, and so the near-term lack of upside to global growth will act as a temporary ceiling on this currency. Nonetheless, the 18-month outlook continues to favor the common currency. Investors have shed Eurozone exposure for more than 10 years and are structurally underweight this region (Chart 11). Hence, EUR/USD should benefit from any positive reassessment of the growth path in the Euro Area compared to that of the US. Additionally, the euro benefits from a structural current account surplus compared to the USD, which translates into a positive basic balance of payments (Chart 12). In an environment in which US real interest rates are low in relation to foreign ones and in which the Fed wants to maintain accommodative monetary conditions to achieve maximum employment, the capital account balance is unlikely to come to the rescue of the dollar. In this context, EUR/USD still possesses significant cyclical upside and is likely to move back above 1.30 by the year’s end of 2022. Chart 11Investors Underweight Eurozone Assets... Chart 12...And The BoP Favors The Euro The Bull Market In Global Stocks Is Not Over The cyclical outlook for equities remains supportive. To begin with, in most years, equities eke out positive returns, as long as a recession is not around the corner; we do not expect a recession anytime soon. Moreover, while the balance of valuation risk and monetary accommodation is not as supportive of stocks as it was last year, it is not pointing to an imminent deep pullback either (Chart 13). The equity risk premium echoes this message. Our ERP measure adjusts for the expected growth rate of earnings as well as the lack of stationarity of the ERP. According to this indicator, equities are not an urgent buy, but they are not at risk of a bear market either (Chart 14). This combination does not prevent corrections, but it suggests that pullbacks of 10% are to be bought. Chart 13Equities Are Not A Screaming Buy... Chart 14...Nor A Screaming Sell Europe’s Structural Underperformance Is Intact… Eurozone stocks have been underperforming their US counterparts since the GFC. As Chart 15 highlights, this subpar performance reflects the decline in European EPS relative to US ones. There is very little case to be made for this underperformance to end on a structural basis. Europe remains saddled with an excessive capital stock and ageing assets. This combination is weighing on European profit margins and RoE (Chart 16). To put an end to this structural underperformance, either European firms will have to consolidate within each industry (allowing cuts to the excess capital stock, to increase concentration, and to boost profit margins) or the regulatory burden must rise in the US to curtail rates of returns in relation to European levels. Chart 15Europe's Underperformance... Chart 16...Reflects Profitability Problems …But The Window For A Cyclical Outperformance Remains Open Despite a challenging structural backdrop, European equities have a window to outperform US stocks, similar to the outperformance of Japan from 1999 to 2006, which only marked a pause within a prolonged relative bear market. European stocks beat their US counterparts when global yields rise (Chart 17). This is because European benchmarks underweight growth stocks relative to US markets. The effect of higher yields on the relative performance of the Euro Area is not limited to the impact of higher discount rates. Yields rise when global economic activity is above trend. As Chart 18 highlights, robust readings of our Global Growth Indicator correlate with an outperformance of the EPS of value stocks compared to growth equities. Thus, when rates rise, Europe should enjoy both a period of re-rating relative to the US and stronger profits. Chart 17Yields Drive European Stocks... Chart 18...And So Does Global Growth Positives For Euro Area Financials Like the broad European market, the financials’ fluctuations are linked to interest rates. Moreover, Euro Area banks also move in line with EUR/USD (Chart 19). As a result, our positive view on both yields and the euro for the next 18 months or so should translate into an outperformance of financials in Europe. Additionally, European banks are inexpensive, embedding not just depressed long-term growth expectations, but also a wide risk premium. Europe’s structural problems mean that investors are correct to expect poor earnings growth from the region’s banks. However, the risk premium is overdone. Eurozone banks are much safer than they were 10 years ago. Banks now sport significantly higher Tier 1 capital adequacy ratios and NPLs have shrunk considerably (Chart 20). Moreover, governmental supports and credit guarantees implemented during the pandemic should limit the upside to NPL in the coming quarters. Finally, the so-called doom-loop that used to bind government and bank solvency together is not as problematic as it once was, because the ECB is a willing buyer of government paper and the NGEU programs create the embryo of fiscal risk sharing that limit these dynamics. As a result, investors should overweight this sector for the next 18 months. Chart 19Financials Have A Window To Shine... Chart 20...And Are Less Risky A Tactical Hedge Our worries about the impact on the global economy of the Chinese credit slowdown are likely to prompt some downside in European cyclical equities relative to defensive ones. Moreover, cyclicals are still significantly overbought relative to defensives, while our relative Combined Mechanical Valuation Indicator confirms the near-term threat (Chart 21). A high-octane vehicle to play this tactical underperformance of cyclicals relative to defensives is to buy Euro Area telecom stocks relative to consumer discretionary equities. Not only are the discretionary stocks massively overbought and expensive relative to telecoms (Chart 22), they also offer a lower RoE. This backdrop makes the short discretionary / long telecoms bet a great hedge for portfolios with a pro-cyclical bias over one- to two-year horizons. Chart 21Cyclicals Are Tactically Vulnerable... Chart 22...But This Risk Can Be Hedged Away Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance
Highlights Over the short term – 1-2 years – the pick-up in re-infection rates in Asia and LatAm states with large-scale deployments of Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery (Chart of the Week). The UAE-Saudi impasse re extending the return of additional volumes of OPEC 2.0 spare capacity to the oil market over 2H21 will be short-lived. The UAE's official baseline production will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly. Over the medium term – 3-5 years out – the risk to the expansion of metal supplies needed for renewables and electric vehicles (EVs) will rise, as left-of-center governments increase taxes and royalties, and carbon prices move higher. Rising metals costs will redound to the benefit of oil and gas producers, and accelerate R+D in carbon- and GHG-reduction technologies. Longer-term – 5-10 years out – the active discouragement of investment in hydrocarbons will contribute to energy shortages. In anticipation of continued upside volatility in commodity prices and share values of oil, gas and metals producers, we remain long the S&P GSCI and COMT ETF, and long equities of producers and traders via the PICK ETF. Feature Our conversations with clients almost invariably leads us to considering the risks to our long-standing bullish views for energy and metals. This week, we reprise some of the highlights of these conversations. In the short term, our bullish call on oil is underpinned by the assumption of continued expansion in vaccinations, which we believe will lead to global economic re-opening and increased mobility, as the world emerges from the devastation of COVID-19. This expectation is once again under scrutiny. On the supply side, the very public negotiations undertaken by the UAE and the leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and Russia – over re-basing the UAE's production reminds investors there is substantial spare capacity from the coalition available for the market over the short term. The slow news cycle going into the US Independence Day holiday certainly was a fortuitous time to make such a point. Chart of the WeekWorrisome Uptick Of COVID-19 Cases KSA-UAE Supply-Side Worries The abrupt end to this week's OPEC 2.0 meeting was unsettling to markets. Shortly after the meeting ended – without being concluded – officials from the Biden administration in the US spoke with officials from KSA and the UAE, presumably to encourage resolution of outstanding issues and to get more oil into the market to keep crude oil prices below $80/bbl (Chart 2). We're confident the KSA-UAE impasse re extending the return of additional volumes of spare capacity to the oil market over 2H21 will be short-lived. The UAE's official baseline production number (i.e., its October 2018 output level) will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly. Coupled with a likely return of Iranian export volumes in 4Q21, this will bring prices down into the mid- to high-$60/bbl range we are forecasting. Chart 2US Pushing For Resolution of KSA-UAE Spat Longer term, markets are worried this incident is a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy, which has lifted oil prices 200% since their March 2020 nadir. At present, the producer coalition has ~ 6-7mm b/d of spare capacity, which resulted from its strategy to keep the level of supply below demand. A breakdown in this discipline – in extremis, another price war of the sort seen in March 2020 or from 2014-2016 – could plunge oil markets into a price collapse that re-visits sub-$40/bbl levels. In our view, economics – specifically the cold economic reality of the price elasticity of supply – continues to work for the OPEC 2.0 coalition: Higher revenues are realized by members of the group as long as relatively small production cuts produce larger revenue gains – e.g., a 5% (or less) cut in production that produces a 20% (or more) increase in price trumps a 20% increase in production that reduces prices by 50%. Besides, none of the members of the coalition possess the wherewithal to endure another shock-and-awe display from KSA similar to the one following the breakdown of the March 2020 OPEC 2.0 meeting. We also continue to expect US shale-oil producers to be disciplined by capital markets, and to retain a focus on providing competitive returns to their shareholders, which will limit supply growth to that which maintains profitability. Until we see actual evidence of a breakdown in the coalition's willingness to maintain its production-management strategy, we will continue to assume it remains operative. Worrisome COVID-19 Re-Infection Trends Reports of increased re-infection rates in Latin American and Asia-Pacific states providing Chinese Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery. Conclusive data on the efficacy of these vaccines is not available at present, based on reporting from Health Policy Watch (HPW).1 The vast majority of these vaccines were purchased in Latin America and the Asia-Pacific region, where ~ 80% of the 759mm doses of the two Chinese vaccines were sold, according to HPW's reporting. This will draw the attention of markets to this risk (Chart 3). Of particular concern are the increases in re-infection rates in the Seychelles and Chile, where the majority of populations in both countries were inoculated with one of the Chinese vaccines. Re-infections in Indonesia also are drawing attention, where more than 350 healthcare workers were re-infected after receiving the Sinovac vaccination.2 The risk of renewed global lockdowns remains small, but if these experiences are repeated globally with adverse health consequences, this assessment could be challenged. Chart 3COVID-19 Returning In High-Vaccination States Transition Risks To A Low-Carbon Economy Over the medium- to long-terms, our metals views are premised on the expectation the build-out of the global EV fleet and renewable electricity generation – including its supporting grids – will require massive increases in the supply of copper, aluminum, nickel, and tin, not to mention iron ore and steel. This surge in demand will be occurring as governments rush headlong into unplanned and unsynchronized wind-downs of investment in the hydrocarbon fuels that power modern economies.3 The big risk here is new metal supplies will not be delivered fast enough to build all of the renewable generation, EVs and their supporting grids and infrastructures to cover the loss of hydrocarbons phased out by policy, legal and boardroom challenges. Such a turn of events would re-invigorate oil and gas production. Renewable energy and electric vehicles are the sine qua non of the drive to achieve net-zero carbon emissions by 2050. However, the rising price of base metals will add to already high costs of rebuilding power grids to make them suitable for green energy. Given miners’ reluctance to invest in new mines, we do not expect metals prices to drop anytime soon. According to Wood Mackenzie, in 2019 the cost of shifting just the US power grid to renewable energy over the next 10 years will amount to $4.5 trillion.4 Given these cost and supply barriers, fossil fuels will need to be used for longer than the IEA outlined in its recent and controversial report on transitioning to a net-zero economy.5 To ensure that fossil fuels can be used while countries work to achieve their net zero goals, carbon capture utilization and storage (CCUS) technology will need to be developed and made cheaper. The main barrier to entry for CCUS technology is its high cost (Chart 4). However, like renewable energy, the more it is deployed and invested in, the cheaper it will become, following the trend seen in the development of renewable energy and EVs, which were aided by large-scale subsidies from governments to encourage the development of the technology. These cost reductions are already visible: In its 2019 report, the Global CCS Institute noted the cost of implementing CCS technology initially used in 2014 had fallen by 35% three years later. Chart 4CCUS Can Be Expensive Metals Mines' Long Lead Times In 2020 the total amount of discovered copper reserves in the world stood at ~ 870mm MT (Chart 5), according to the US Geological Service (USGS). As of 2017, the total identified and undiscovered amount of reserves was ~ 5.6 billion MT.6 The World Bank recently estimated additional demand for copper would amount to ~ 20mm MT p.a. by 2050 (Chart 6).7 Glencore’s recently retired CEO Ivan Glasenberg last month said that by 2050, miners will need to produce around 60mm MT p.a. of copper to keep up with demand for countries’ net zero initiatives.8 Even with this higher estimate, if miners focus on exploration and can tap into undiscovered reserves, supply will cover demand for the renewable energy buildout. Chart 5Copper Reserves Are Abundant Chart 6Call On Base Metals Supply Will Be Massive Out To 2050 While recent legislative developments in Chile and Peru, which together constitute ~ 34% of total discovered copper reserves, could lead to significantly higher costs as left-of-center governments re-write these states' constitutions, geological factors would not be the main constraint to copper supply for the renewables energy buildout: Even if copper mining companies were to move out of these two countries, there still is about 570 million MT in discovered copper reserves, and nearly ten times that amount in undiscovered reserves. As we have written in the past, capital expenditure restraint is the principal reason the supply side of copper markets – and base metals generally – is challenged (Chart 7). Unlike in the previous commodity boom, this time mining companies are focusing on providing returns to shareholders, instead of funding the development of new mines (Chart 8). Chart 7Copper Prices Remains Parsimonious Chart 8Shareholder Interests Predominate Metals Agendas Of course, it is likely metals miners, like oil producers, are waiting to see actual demand for copper and other base metals pick up before ramping capex. Sharp increases in forecasted demand is not compelling for miners, at this point. This means metals prices could stay elevated for an extended period, given the 10-15-year lead times for copper mines (Chart 9). For example, the Kamoa-Kakula mine in the Democratic Republic of Congo (DRC) now being brought on line took roughly 24 years of exploration and development work, before it started producing copper. Technological breakthroughs that increase brownfield projects’ productivity, or significant increases in the amount of recycled copper as a percent of total copper supply would address some of the price pressures arising from the long lead times associated with the development of new copper supply. Another scenario with a non-trivial probability that threatens the viability of metals investing is a breakthrough – or breakthroughs – in CCUS technology, which allows oil and gas producers to remove enough carbon from their fuels to allow firms using these fuels to achieve their net-zero carbon goals. Chart 9Long Lead Times For Mine Development Investment Implications Short-term supply-demand issues affecting the oil market at present are transitory, and do not signal a shift in the fundamentals supporting our bullish call on oil. Our thesis based on continued production discipline remains intact. That said, we will continue to subject it to rigorous scrutiny on a continual basis. Our average Brent forecast for 2021 remains $66.50/bbl, with 2H21 prices averaging $70/bbl. For 2022 and 2023 we continue to expect prices to average $74 and $81/bbl, respectively (Chart 10). WTI will trade $2-$3/bbl lower. Our metals view has become slightly more nuanced, thanks to our client conversations. One of the unintended consequences of the unplanned and uncoordinated rush to a net-zero carbon future will be an improvement in the competitive position of oil and gas as transportation fuels and electric-generation fuels going forward. This will be driven by rising costs of developing and delivering the metals supplies needed to effect the net-zero transition. We expect markets will provide incentives to CCUS technologies and efforts to decarbonize oil and gas fuels, which will contribute to the global effort to arrest rising temperatures. This suggests the rush to sell these assets – which is underway at present – could be premature.9 In the extreme, this could be a true counterbalance to the metals story, if it plays out. Chart 10Our Oil Price View Remains Intact Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish The monthly OPEC 2.0 meeting ended without any action to increase monthly supplies, following the UAE's bid to increase its baseline reference production – determined based on October 2018 production levels – to 3.8mm b/d, up from 3.2mm b/d. S&P Global Platts reported the UAE's Energy Minister, Suhail al-Mazrouei, advanced a proposal to raise its monthly production level under the coalition's overall output deal, while KSA's energy minister, Prince Abdulaziz bin Salman, insisted the UAE follow OPEC 2.0 procedures in seeking an output increase. We do not expect this issue to become a protracted standoff between these states. The disagreement between the ministers is procedural to substantive. Remarks by bin Salman last month – to wit, KSA has a role in containing inflation globally – and his earlier assertions that production policy of OPEC 2.0 would be driven by actual oil demand, as opposed to forecasted oil demand, suggest the Kingdom is not aiming for higher oil prices per se. Base Metals: Bullish Spot benchmark iron ore (62 Fe) prices traded above $222/MT this week in China on the back of stronger steel demand, according to mining.com (Chart 11). Market participants are anticipating further steel-production restrictions and appear to be trying to get out in front of them. Precious Metals: Bullish The USD rally eased this week, allowing gold prices to stabilize following the June Federal Open Market Committee (FOMC) meeting. In the two weeks since the FOMC, our gold composite indicator shows that gold started entering oversold territory (Chart 12). We believe gold prices will start correcting upwards, expecting investor bargain-hunting to pick up after the price drop. The mixed US jobs report, which showed the unemployment rate ticked up more than expected, implies that interest rates are not going to be raised soon. Our colleagues at BCA Research's US Bond Strategy (USBS) expect rates to increase only by end-2022.10 This, along with slightly higher odds of a potential COVID-19 resurgence, will support gold prices in the near-term. Ags/Softs: Neutral The USDA's Crop Progress report for the week ended 4 July 2021 showed 64% of the US corn crop was in good to excellent condition, down from the 71% reported for the comparable 2020 date. The Department reported 59% of the bean crop was in good to excellent shape vs 71% the year earlier. Chart 11 Chart 12 Footnotes 1 Please see Are Chinese COVID Vaccines Underperforming? A Dearth of Real-Life Studies Leaves Unanswered Questions, published by Health Policy Watch, June 18, 2021. 2 According to HPW, the World Health Organization's Emergency Use Listing for these two vaccines "were unique in that unlike the Pfizer, AstraZeneca, Moderna, and Jonhson & Johonson vaccines that it had also approved, neither had undergone review and approval by a strict national or regional regulatory authority such as the US Food and Drug Administration or the European Medicines Agency. Nor have Phase 3 results of the Sinopharm and Sinovac trials been published in a peer-reviewed medical journal. More to the point, post-approval, any large-scale tracking of the efficacy of the Sinovac and Sinopharm vaccine rollouts by WHO or national authorities seems to be missing." 3 Please see A Perfect Energy Storm On The Way, which we published on June 3, 2021 for additional discussion. It is available at ces.bcaresearch.com. 4 Please refer to The Price of a Fully Renewable US Grid: $4.5 Trillion, published by greentechmedia 28 June 2019. 5 Please refer to the IEA's Net Zero By 2050, published in May 2021. 6 Please refer to USGS Mineral Commodity Summaries, 2021. 7 Please refer to Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition, published by the World Bank. 8 Please refer to Copper supply needs to double by 2050, Glencore CEO says, published by reuters.com on June 22, 2021. 9 Please see the FT's excellent coverage of this trend in A $140bn asset sale: the investors cashing in on Big Oil’s push to net zero published on July 6, 2021. 10 Please refer to Watch Employment, Not Inflation, published by the USBS on June 15, 2021. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Underweight (Upgrade Alert) We are currently underweight US banks, but the macro environment is changing and today we put this sub-sector on an upgrade alert looking to push it to a neutral allocation. The news on the buyback and dividend fronts is encouraging as banks will be allowed to resume their shareholder friendly activities that were halted last year due to the Fed’s Stress Test. Already, financials stocks are at the front of the pack with a roughly 3% total yield that is likely to increase further. Tack on the current search for yield environment, and the allure of financials equities becomes even more tempting. Bottom Line: We are putting banks on our upgrade alert watchlist. Please see an upcoming Strategy Report where we delve deeper into the buyback and dividend topics.
Highlights Inflation is set to decelerate, job creation has a speed limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy. This means that in the second half of the year: Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks. Fractal trade shortlist: Brazilian real, Saudi Tadawul All Share, and Marine Transportation. Feature Chart of the WeekThe 60 Percent Correction In Lumber Shows What Happens When Supply Bottlenecks Ease. Are Used Cars Next? As Supply Bottlenecks Ease, Inflation Will Cool Since mid-March, US inflation has surged to 5 percent. Yet bond yields have drifted lower, by almost 50 bps in the case of the 30-year T-bond yield, equating to a handsome return of 12 percent. The seeming contradiction between rising inflation and declining bond yields has puzzled some people, but it shouldn’t. In 2009, the same pattern occurred in reverse. Inflation collapsed, culminating in a modern era low of -2 percent in July 2009. Yet while inflation was collapsing, bond yields rose sharply (Chart I-2 and Chart I-3). Chart I-2In 2009, Bond Yields Rose When Year-On-Year Inflation Fell Chart I-3In 2021, Bond Yields Fell When Year-On-Year Inflation Rose We can explain this seeming contradiction with an analogy from driving. The inflation rate is like your average speed over the past mile. But the bond market cares much more about your average speed over the next mile, or even over the next 5-10 miles. If you are driving at a constant speed, then your speed over the past mile is a good guide to your future speed. But if you have been driving unusually fast or unusually slowly, there is a more important predictor of your future speed. That important predictor is your acceleration – meaning, what is happening to your speed over successive hundred yards stretches. In the same way, during episodes of unusually low or unusually high inflation, the bond market focusses on the monthly rate of inflation, and specifically the moment that it stops decreasing, as in early-2009, or stops increasing, as in mid-2021. In 2008, after a long sequence of declining monthly rates of inflation that went deep into negative territory, the December 2008 print marked the first substantial increase. Hence, the bond yield also bottomed in December 2008 (Chart I-4), even though annual inflation did not bottom until July 2009. Chart I-4In 2009, Bond Yields Bottomed When Month-On-Month Inflation Bottomed Similarly, in 2020-21, after a six month sequence of increasing monthly rates of inflation, the May 2021 print marked the end of the rising trend. To the extent that this was anticipated, most of the decline in the bond yield has happened since mid-May (Chart I-5). Chart I-5In 2021, Bond Yields Topped When Month-On-Month Inflation Topped Since mid-May, the 60 percent crash in the lumber price shows what happens when supply bottlenecks ease. Other prices that are being supported by temporary supply constraints – such as used car prices – are likely to suffer the same fate (Chart of the Week). Hence, so long as the coming monthly prints confirm an ongoing deceleration in inflation, the current rally in bonds will stay intact. Jobs: The Hard Work Starts Now Staying on the theme of speed, there is a well-defined speed limit to every post-recession jobs recovery. In A Fed Rate Hike By Early 2023 Is Pie In the Sky, we pointed out the remarkable consistency in the pace of post-recession US jobs recoveries. The last five recessions had different causes, severities, durations and peak unemployment rates. Yet in the recoveries that followed each recession, the unemployment rate declined at a remarkably consistent pace of 0.4-0.5 percent per year (Table I-1). Table I-1After Every Recession, The Pace Of Recovery In The Jobs Market Is Near-Identical Reassuringly at the last FOMC press conference, Jay Powell supported this thesis: Most of the act of sort of going back to one's old job – that's kind of already happened. So, this is a question of people finding a new job. And that's just a process that takes longer. There may be something of a speed limit on it. You've got to find a job where your skills match, you know, what the employer wants. It's got to be in the right area. There's just a lot that goes into the function of finding a job. Powell’s comments lead to two further points: The act of going back to one’s old job for those on ‘temporary layoff’ is relatively straightforward. For job creation, this is the low hanging fruit, most of which has already been picked. Now comes the much harder part – finding jobs for those ‘not on temporary layoff’ whose numbers have barely declined from the peak (Chart I-6). Chart I-6For Job Creation, The Low Hanging Fruit Has Already Been Picked One way of encapsulating this is to observe that the unemployment rate – including those on temporary layoff – has already made 80 percent of the journey from its recession peak to the February 2020 trough, which makes it seem that the jobs recovery is largely done. However, the unemployment rate for those not on temporary layoff has made only 25 percent of the journey (Chart I-7). Moreover, this process is not a straight line, it is a curve. The first quarter of the journey is the easiest, then it gets harder. Chart I-7The Hard Part Is Finding Jobs For Those Unemployed 'Not On Temporary Layoff' As we, and Jay Powell, have pointed out, the process to reduce this unemployment rate has a remarkably consistent speed limit of 0.4-0.5 percent per year. Starting at the current rate of 2.5 percent and a target of 1.5 percent, this means full employment will not be reached before the second half of 2023. And even this assumes clear blue skies for the world economy through the next two years, which is a tall order. We conclude that the market pricing of a Fed funds rate lift-off in December 2022 is much too optimistic, making the December 2022 Eurodollar contract a good buy. The End Of Pandemic Restrictions Will Unleash Super-Spreaders On July 19, the UK will remove all its domestic pandemic restrictions – meaning no more facemasks, social distancing, and limits on the size of gatherings. This doesn’t mean that the pandemic is over in the UK. Far from it. The delta variant of the virus is rampant. Rather, with a large portion of the population vaccinated, the government is replacing state-imposed laws and regulations with a libertarian onus on personal responsibility. Given that Covid-19 is not going away, the UK strategy raises a fundamental question. Other than implementing a vaccination program, what role should a government take in containing the virus? In Who’s Right On The Pandemic – Sweden Or Denmark? we revealed two important findings: First, it is a misunderstanding that state-imposed restrictions cause the collapse in social consumption. This is a classic confusion between correlation and causation. The true cause of the recession is that a virulent disease focuses millions of people on self-preservation, shunning crowds and public places. But to the extent that the pandemic also leads to state-imposed restrictions, many people blame the slowdown on these correlated restrictions rather than on the underlying cause – the voluntary change in behaviour. Second, without state-imposed restrictions, the majority will voluntarily change their behaviour to avoid catching and spreading the virus, but a minority will not. When a virus is spreading, this is critical because a tiny minority of so-called ‘super-spreaders’ is responsible for most infections. Put simply, economic growth depends on the behaviour of the majority and in a pandemic the majority will voluntarily reduce their social consumption. This explains why libertarian Sweden and lockdown Denmark suffered similar contractions in their economies (Chart I-8). Chart I-8Libertarian Sweden Has Not Significantly Outperformed Lockdown Denmark... In contrast, containing the virus depends on restricting the minority of super-spreaders. Which explains why libertarian Sweden suffered a much worse outbreak of the disease than lockdown Denmark (Chart I-9). Chart I-9...But Libertarian Sweden Has Suffered Many More Covid-19 Casualties The worry now is that the end of state-imposed restrictions will unleash super-spreaders and super-spreading events. This will allow the virus to replicate, mutate, and create new variants which are potentially more transmissible and resistant to existing vaccines. Pulling together our three themes for the second half of the year, inflation is set to decelerate, job creation has a natural speed-limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy. This means that: Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks Candidates For Countertrend Reversal This week, we present three candidates for countertrend reversal. First, the Brazilian real’s recent surge has hit expected resistance at 65-day fractal fragility. A good way to play a continued reversal is to short BRL/COP (Chart I-10). Chart I-10The Brazilian Real Is Correcting Second, within emerging markets, the strong rally in the Saudi equity market is vulnerable to a setback, especially versus other markets. A good way to play this is to short the Saudi Tadawul All Share index versus the FTSE Bursa Malaysia KLCI, given that the 260-day fractal structure is at the point of fragility that marked the major top in 2014 (Chart I-11). Chart I-11The Saudi Stock Market Is Vulnerable To A Setback Finally, coming full circle to short-term supply bottlenecks, one major beneficiary has been the Marine Transportation sector which, since February, has outperformed the world market by 70 percent. As the supply bottlenecks ease, this is vulnerable to correction, especially as the 260-day fractal structure is at the point of fragility that marked the major top in 2007 (Chart I-12). Chart I-12Underweight Marine Transportation Hence, this week’s recommended trade is to underweight Marine Transportation versus the market, setting the profit target and symmetrical stop-loss at 16.5 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic Chart 4South Asia Is Characterized By Very Low Per Capita Incomes To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.