Business Cycles

Highlights Stocks tend to perform worse when unemployment is low. Since 1950, the S&P 500 has risen at an annualized pace of 12% when the unemployment rate was above its historic average compared to 6% when the unemployment rate was below its average. Three reasons help explain this relationship: 1) The unemployment rate has historically been mean-reverting; 2) Low unemployment often leads to monetary tightening; and 3) Valuations are usually more stretched when unemployment is low. In the spring of 2020, stocks benefited from what turned out to be a very auspicious environment: A steady decline in the unemployment rate from very high levels, assisted by a massive dose of monetary and fiscal stimulus. Today, the situation is less clear-cut. The labor market has improved dramatically, while both monetary and fiscal policy are turning less accommodative. Nevertheless, the Fed is unlikely to hike rates for at least 12 months, and it will take much longer than that for monetary policy to turn restrictive. This suggests that we are still in the middle-to-late stages of a business cycle expansion that began following the Great Recession (and was only briefly interrupted by the pandemic). Historically, cyclical stocks have done well during this phase of the business cycle. To the extent that cyclicals are overrepresented in overseas indices, investors should favor non-US stock markets. Non-US stocks also trade at a substantial valuation discount to their US peers. A Surprising Relationship One of the best pieces of advice I received when I was starting my research career was to get to the punchline as soon as possible. As a strategist, you are not writing a detective novel where the answers are shrouded in mystery until the very end. You are providing conclusions to readers with supporting evidence. Chart 1Stocks Do Best When Unemployment Is High With that in mind, let me answer the question posed in the title of this report: Is low unemployment good or bad for stocks? As Chart 1 shows, the answer is bad. The interesting issues are why it is bad and what this may mean for investors today. There are three key reasons why low unemployment has typically corresponded with paltry equity returns: The unemployment rate has historically been mean-reverting: Low unemployment is often followed by high unemployment. And, when the unemployment rate starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession occurring (Chart 2). Chart 2When Unemployment Starts Rising, It Usually Keeps Rising Low unemployment often leads to monetary tightening: An economy can only grow at an above-trend pace if there is labor market slack. Once the slack runs out, growth is liable to weaken as supply-side constraints kick in. Worse yet, labor market overheating has historically prompted central banks to raise rates (Chart 3). Higher rates in the context of slowing growth is toxic for stocks. Valuations are usually more stretched when unemployment is low: During the post-war period, the S&P 500 has traded at an average Shiller P/E ratio of 22.5 when the unemployment rate was below its historic average compared to 16.3 when the unemployment rate was above its average. Implications For The Present Day Stocks fare best when unemployment is high but falling. In contrast, stocks fare the worst when unemployment is low and rising (Chart 4). My colleague Doug Peta, BCA’s Chief US Investment Strategist, reached a similar conclusion in his August report entitled Level Or Direction? Chart 3Low Unemployment Often Leads To Monetary Tightening Chart 4Stocks Do Best When Unemployment Is Falling From High Levels   In the spring of 2020, stocks benefited from what turned out to be a very auspicious environment: A steady decline in the unemployment rate from very high levels, assisted by a massive dose of monetary and fiscal stimulus. Controversially at the time, this led us to argue that the pandemic could lead to much higher stock prices. Chart 5There Is Still Slack Today, the situation is less clear-cut. On the one hand, the unemployment rate has fallen dramatically, while monetary and fiscal policy are turning less accommodative. This week, the ECB reduced the pace of net asset purchases under the PEPP. The Fed will start paring back asset purchases by the end of this year. Governments are also withdrawing fiscal policy support. In the US, emergency federal unemployment benefits expired, somewhat ironically, on Labor Day. On the other hand, the unemployment rate in most economies is still above pre-pandemic levels. In the US, the unemployment rate for prime-age workers is 1.7 percentage points higher than in February 2020, while the employment-to-population ratio is 2.4 points lower (Chart 5). The presence of labor market slack ensures that policy support will be withdrawn only gradually.   Granted, core CPI inflation in the US is running above 4%. Standard Taylor Rule equations suggest that the Fed funds rate should be well above zero (Chart 6). That said, these equations use realized inflation, which may be misleading given that both market participants and Fed officials expect inflation to fall rapidly (Chart 7). Indeed, the widely followed 5-year/5-year forward TIPS breakeven rate is below the Fed’s comfort zone (Chart 8).1 With long-term inflation expectations still subdued, there is no urgency for the Fed to sound more hawkish. Chart 6What Rate Does The Taylor Rule Prescribe? Chart 7Investors Expect Inflation To Fall Rapidly From Current Levels Chart 8Long-Term Inflation Expectations Are Muted Cyclical Stocks Usually Do Best In The Latter Innings Of The Business Cycle Expansion Monetary policy is unlikely to become restrictive in any major economy during the next 18 months, which should allow global growth to remain at an above-trend pace. Hence, it is too early to turn bearish on stocks. Nevertheless, given that the unemployment rate in most countries is closer to a trough than to a peak, it is reasonable to conclude that we are somewhere in the middle-to-late stages of a business cycle expansion that began following the Great Recession (and was only briefly interrupted by the pandemic). As Chart 9 shows, cyclical equity sectors, such as industrials, energy, and materials, typically do best in the latter innings of business cycle expansions. Such was the environment that prevailed in 2005-08, and such will be the environment that prevails over the coming quarters as the unemployment rate falls further, capital spending increases, and commodity prices rise further. Chart 9The Business Cycle And Equity Sectors Increased government infrastructure spending should help cyclical sectors. The US Congress is set to pass a 10-year $500 billion package. The EU’s €750 billion Next Generation fund is finally up and running. Chinese local government infrastructure spending is poised to accelerate over the remainder of the year.   Chart 10The Dollar Is A Countercyclical Currency Chart 11Past Another Covid Wave A weaker US dollar should also buoy cyclical stocks (Chart 10). As a countercyclical currency, the greenback usually weakens when global growth is strong. A cresting in the Delta variant wave should help jumpstart global growth over the coming months (Chart 11). Meanwhile, interest rate differentials have moved sharply against the US dollar, while the US trade deficit has widened noticeably (Charts 12A & B).   Chart 12AInterest Rate Differentials Have Moved Against The Dollar Chart 12BThe US Trade Deficit Has Widened Noticeably Cyclical sectors are overrepresented outside the US (Table 1). Although not a classically cyclical sector, financials are also overrepresented in overseas indices. BCA’s global fixed-income strategists recommend a moderately underweight duration stance. As bond yields rise, bank shares should outperform (Chart 13). In contrast, tech stocks often lag in a rising yield environment. Table 1Cyclicals Are Overrepresented Outside The US Chart 13Higher Rates: A Boon For Banks And A Bane For Tech How Expensive Are Stocks? A high Shiller P/E predicts low future returns (Chart 14). Today, the Shiller P/E stands at 37 in the US. This is consistent with an expected 10-year total real return of close to zero for the S&P 500. Thus, the long-term outlook for US stocks is poor. We stress the words “long term.” As the bottom panel of Chart 14 shows, no matter what the starting point of valuations is, the average return over short-term horizons is very low relative to realized volatility. This is another way of saying that valuations provide a great deal of information about the long-term outlook for stocks, but little information about their near-term direction. Over horizons of about 12 months, the business cycle drives the stock market, as a simple comparison between purchasing manager indices and stock returns illustrates (Chart 15).   Chart 14Valuation Is The Single Best Predictor Of Long-Term Equity Returns Chart 15AThe Business Cycle Drives Cyclical Swings In Stocks Chart 15BThe Business Cycle Drives Cyclical Swings In Stocks Outside the US, the Shiller P/E stands at 20. In emerging markets, it is only 16 (Chart 16). This is significantly below US levels, implying that the long-term prospect for equities is much more attractive abroad. Thus, both medium-term cyclical factors and long-term valuation considerations favor non-US stocks.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 16US Stocks Are Pricey Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

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 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 Chart 3Trade 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? 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 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) 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... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China 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 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 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 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 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 Chart 13India Likely To Expand Fiscal Spending Soon 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 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. 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 Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar

Highlights The dollar smile theory was valid around the COVID-19 crisis but does not stand the test of time. A more useful framework for determining the long-term trend in the dollar is observing global business cycle dynamics. The 2000s experience could provide a useful roadmap for the dollar this coming decade. We remain dollar bears over a 9-to-12-month horizon, although the dollar could stage a short-lived rally in the interim. Feature The “dollar smile” theory1 is the premise that the dollar tends to rise when the US economy is either too strong or too weak. Only in the precise environment, when the US economy is neither too hot nor too cold would you experience a dollar decline (Chart I-1). Chart I-1The Dollar Smile Theory This theory particularly resonates with traders and financial speculators as each handle of the smile can be explained by economic theory. For example, when the US economy is running hot, this usually prompts the Federal Reserve to hike interest rates. This supports the dollar. When the US economy is entering a recession, this is generally accompanied by a flight to safety. Inflows into safe-haven US bonds and defensive sectors of the stock market would also tend to boost the dollar. The fact that the dollar can rise in these polarizing set of circumstances makes a long dollar view particularly attractive as the default position. The key questions therefore for investors are: First, how does this theory hold up in terms of evidence? and, second, how should FX portfolios be positioned in the current environment? The Evidence During the height of the COVID-19 crisis, the smile theory certainly proved correct. Chart I-2 shows that the DXY index tended to rise approximately 58% of the time when the S&P 500 was either up by 2% or down by 2%. However, when the sample size is broadened, even to a few years, the theory falls apart. From 2010-2020, the DXY index rose only 37% of the time when the S&P 500 was up 2%, while it rose almost 50% of the time when the S&P 500 was down 2% (Chart I-3). Meanwhile, this sample size is particularly biased since during that period, the dollar was in a bull market, and the US economy was quite strong. Chart I-2The Dollar Smile Around The 2020 Pandemic Chart I-3The Dollar Smile Around Full Business Cycles Chart I-4US Industrial Production And The Dollar: No Correlation In economic terms, we get a similar picture. The relationship between US industrial production and the greenback is weak at best, with little evidence of a smile (Chart I-4). For example, there was no discernable trend in the dollar when US industrial production was between 0-5%, or even 5-10%. Admittedly, the dollar does rise when US manufacturing is in recession. A More Useful Framework Chart I-5US Relative Growth And The Dollar: Linear Correlation While the dollar is a complex variable, explaining its longer-term trend boils down to two simple rules of thumb: Is the global economy recovering or contracting? And if so, is the US leading or lagging this recovery? Chart I-5 shows that the dollar tends to rise when US economic activity is picking up relative to the world, but tends to fall otherwise, albeit with a few outliers. Meanwhile, one of the reasons the US dollar has done well during recessions is that the US economy generally has had more shallow recessions than other advanced economies in recent years. Through this lens, the US performs comparatively better during global downturns (Chart I-6). Going forward, the IMF predicts that non-US growth should fare better than growth in the US over the next few years. We side with the IMF: The global economic recovery will remain intact and will rotate from the US to other economies. Chart I-6US Growth Usually Outperforms During Recessions Chart I-7Spectacular Recovery In Vaccinations Outside The US The primary rationale is that most G10 countries lagged the US in their vaccination campaigns in 2020 and earlier this year. That is starting to change now, as vaccinations in the rest of the G10 are ramping up (Chart I-7). Meanwhile, vaccinations are proving effective against death and hospitalizations for the Delta variant of the COVID-19 virus. A turnaround in the vaccination campaign would not only boost public opinion about the COVID-19 response but would also be a welcome fillip to much subdued consumer and business sentiment outside the US. Taking a step back, there is a strong case to be made that cyclically, both eurozone and Japanese growth could surprise to the upside due to pent-up demand. For the eurozone, the debt crisis from 2010-2012 was a severe blow to the recovery. In Japan, rolling crises from the Fukushima disaster in 2011 to the consumption tax hikes both in 2014 and 2019 were growth handicaps. Chinese monetary tightening in 2015 caused a sharp manufacturing recession that was a severe blow to non-US economies, including Japan and the eurozone. This time around, coordinated monetary and fiscal stimulus could allow for a few years of a genuine growth recovery. In a nutshell, the dollar smile that occurred around the pandemic last year was due to the uncertainty about the future path of growth, while the US was leading the world in both monetary and fiscal stimulus. The US also led in the vaccination campaign. As other economies adopt this template, the smile should fade, as has empirically been the case over time. Echoes From The 2000s The 2000s experience could provide a useful roadmap for the dollar in this coming decade (Chart I-8). US growth was underperforming the rest of the world during that time. The primary driver was a commodity boom driven by massive infrastructure spending in China. This time around, a concerted push towards green energy will sustain bull markets in metals such as copper, nickel, cobalt, aluminum, and silver, benefiting the economies of producer countries (Chart I-9). Leaders in building renewable energy infrastructure, such as Europe, could also see a boom as demand for their goods and services rise. Chart I-8A Roadmap For The Dollar In The Next Decade Chart I-9At The Cusp Of A New Commodity Super Cycle? The aftermath of the tech bubble bust created extremely easy policy settings for the US. The Federal Reserve cut interest rates to a low of 1% in 2003. Meanwhile, fiscal policy was much more accommodative than what was needed to close the output gap. The combination led to a massive expansion in the US twin deficits, a similar situation to today (Chart I-10). Chart I-10A 2000s Roadmap Chart I-11Real Yields: Now Versus Then Excess demand in the US started to create inflationary pressures, with headline inflation consistently between 2-4% from 2000-2008. Real rates in the US cratered, which hurt the dollar. This time around, inflation is rising fastest in the US (even if it is transitory). Meanwhile, The Fed is the only central bank that has an asymmetric inflation target. Other central banks (such as the Reserve Bank of New Zealand, the Bank of Canada or Norges Bank) have stated they will normalize policy, even though they also view their inflation as transitory. So real rates are and will be rising faster outside the US (Chart I-11). In short, most of the conditions that have usually characterized a dollar bear market for a decade or so are in place today. The Federal Reserve is committed to staying easy, US real rates are depressed, and growth should be stronger outside the US compared to within it, a similar template to what we saw in the 2000s. From A Dollar Shortage To An Avalanche The dollar smile theory works particularly well when there is a shortage of dollars, like in 2020. The lack of dollar liquidity was a tailwind behind the dollar bull market during the last decade. Today, the Fed’s balance sheet is still expanding, and the massive liquidity injection from quantitative easing has tremendously improved the global supply of dollars. One measure of global dollar liquidity is the sum of the Federal Reserve’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has exacerbated a blow-up somewhere, typically among other countries running twin deficits (Chart I-12). For example, since the global financial crisis, a deceleration in this measure coincided with the European debt crisis, the China slowdown, and more recently, the COVID-19 crisis, with steep depreciation in many procyclical currencies and a vicious rally in the dollar. Chart I-12An Explosion In The US Monetary Base Fast forward to today and it is difficult to imagine such a scenario playing out over the next 9-12 months. The Fed has swap lines with many foreign developed and emerging market central banks that can draw on dollar liquidity until the end of this year. These lines are likely to be extended if the economic environment deteriorates before year-end. Meanwhile, the lack of uptake from these lines suggests foreign central banks are flush with dollars (Chart I-13). The Federal Reserve’s custody holdings also argue that there is little shortage of dollars internationally, compared to 2008 or 2020 (Chart I-14). With the US current account deficit widening, outflows of US dollars will continue to keep global dollar liquidity flush. Chart I-13Swap Lines Are Not Being Tapped Chart I-14Custody Holdings Are Picking Up Cross-currency basis swaps are well contained, suggesting no US dollar funding pressures abroad. Chart I-15Rising Non-USD Debt It is important to note that euro- and yen-denominated debt are also expanding (Chart I-15). These are smaller in outstanding amounts than US-denominated debt but reflect the gradual shift in the allocation of currencies away from dollars. In a nutshell, the system is awash with both dollars and other international reserve currencies, limiting the negative feedback loop that dollar shortages have usually triggered. Concluding Thoughts We made the case last week that the dollar is experiencing a countertrend bounce, likely to continue over the next month or so. Beyond that, however, the dollar should depreciate towards the end of the year into next year. Meanwhile, our analysis suggests the dollar smile theory works best near recessions when the US economy is likely to outperform and the safe-haven status of US Treasuries is likely to buffet the greenback. Outside of these periods which represent only 5% of the last four decades, the dollar smile theory falls apart.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2   There were a few strong data releases out of the US: Inflation continues to inflect higher in the US. Headline CPI came out at 5.4% versus expectations of 4.9% in June. Core came in at 4.5% versus expectations of 4.0%. The PPI report was equally robust, with core prices rising well above expectations to the tune of 5.6%. The NFIB small business optimism survey jumped from 99.6 to 102.5. Empire manufacturing data for July was 43 versus 17.4 the prior month. The US dollar DXY index is up 0.4% this week. The big data release was the increase in US inflation but relative calm in bond markets seems to cement the view that financial participants consider it transitory. There is still scope for the US dollar to work off oversold conditions, but our bias is that it will be lower in the next 9-12 months.   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 Chart II-4EUR Technicals 2   There was scant data out of the eurozone this week: The Bloomberg GDP survey showed that both Q2 and Q3 GDP growth were revised higher. 2022 growth was also revised higher from 4.2% to 4.3%. In the same survey, there was no change expected in policy rates in the foreseeable future. CPI across eurozone countries was in line with expectations: 2.5% in Spain, 2.1% in Germany and 1.9% in France for the month of June. Over the weekend, in a Bloomberg interview, Christine Lagarde told us to expect a significant update to the eurozone’s monetary policy and forward guidance in the July 22 meeting. Our bias is that given the new symmetric inflation target, PEPP will be rolled over into a new program, revised asset purchases will be announced to accommodate for climate change, and possibly more forward guidance that gives us a window into when the ECB will exit negative rates. 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 Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2   There was some positive news out of Japan this week: Core machine orders rose 12.2% year on year in May, versus an expectation of a 6.3% increase. PPI came in at 5% year on year in June, in line with expectations. Machine tool orders rose 97% year on year in June. Importantly, domestic orders grew faster. The yen was down 0.14% against the dollar this week, after a stellar performance last week. The yen continues to sit in a sweet spot among G10 currencies. Falling nominal yields elsewhere are increasing the appeal of yen cash in real terms. Meanwhile, there is the upshot of cyclical improvement in Japan, which will benefit inflows into yen assets.   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 Chart II-8GBP Technicals 2   There was significant data out of the UK this week: The 3-month-on-3-month GDP release for May came in at 3.6%, below expectations. Industrial production growth for May was 20.6% year on year, below the 27.5% increase in April. The trade deficit improved from GBP 11bn to GBP 8.5bn. CPI was above target in June, with core at 2.3% and the RPI at 3.9%. The house price index rose 10% year on year in May. Employment increased 25K in May, which disappointed expectations of a 91K increase. The pound rose 0.5% against the US dollar this week. The market reacted positively to the upside surprise in inflation, suggesting the BoE might normalize policy sooner than expected.   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 Chart II-10AUD Technicals 2   There were a few important data releases out of Australia this week: NAB business conditions deteriorated. The conditions component fell from 37 to 24 in June, while the confidence component fell from 20 to 11. Westpac consumer confidence rose slightly to 108.8 from 107.2 in July. The employment report was better than expected. There were 29.1K jobs added in June, pushing the unemployment rate down to 4.9%. The mix was also great with 51.6K full-time jobs added versus a loss of 22.5K part-time jobs. The AUD was up 0.13% this week against the USD. Melbourne has joined Sydney in the lockdown, and so there is room for economic data to keep disappointing over the next few weeks. In hindsight, the RBA’s decisively dovish bias relative to other central banks seemed to be the appropriate strategy. In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for 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 Chart II-12NZD Technicals 2   The was scant data out of New Zealand this week: REINZ house prices rose 6.2% year on year in June. Net migration for May was 1182 versus 1087 the prior month. The NZD was up 60bps versus the US dollar this week. While the RBNZ kept interest rates at 0.25%, it signaled QE will end on July 23, a full year ahead of schedule. Markets are now priced for a rate hike as early as August. Our long CHF/NZD position was offside in this environment. Our conviction on this trade has fallen given the hawkish shift from the RBNZ, but we recommend holding onto this trade, as a reset in global asset prices could increase currency volatility and hurt the pair. 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 Chart II-14CAD Technicals 2   Data out of Canada this week has been robust: The employment report was stellar. 231K new jobs were added in June. The unemployment rate fell from 8.2% to 7.8%. The participation rate also increased from 64.6% to 65.2%. The BoC kept interest rates on hold at 0.25% but cut its weekly asset purchases from C$3 billion to C$2 billion. The Bloomberg Nanos Confidence index held steady at 66.4. The CAD fell by 0.2% this week and was flat on the announcement. The loonie has softened since the bottom in the DXY index, as overbought conditions are being worked off. There was no new information out of the recent BoC meeting – the central bank is on pace to start lifting rates ahead of the Fed as long as Canada approaches full employment and inflation remains above target. This will limit downside on the CAD. 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 Chart II-16CHF Technicals 2   The was scant data out of Switzerland this week: Producer prices rose by 2.9% year on year in June. Total sight deposits were unchanged at CHF 712 bn for the week of July 9. The Swiss franc was down 0.3% this week, after a nice run-up last week. Falling yields will continue to improve the relative appeal of the franc, like the yen. The franc will also benefit from safe-haven inflows if equity markets correct. We are long the CHF/NZD cross on this basis and are sticking with this recommendation. 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 Chart II-18NOK Technicals 2   Data out of Norway is improving: June CPI came in at 2.9% as expected. Underlying CPI was also 1.4%. PPI came in at 37.1% year on year in June, driven by high oil prices. The trade balance improved from NOK 15.5bn to NOK 25bn in June. The NOK was down by 1.7% this week against the dollar. We have a limit-buy on the Scandinavian currencies at -1.4% from current levels, on expectation that the sell-off is short lived. 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 Chart II-20SEK Technicals 2   Recent data from Sweden have been somewhat soft: Headline CPI fell from 1.8% in May to 1.3% in June. The core measure also fell from 2.1% to 1.6% but was better than expectations. The core core measure came in at 0.9% as expected. The SEK was the weakest G10 currency this week, falling by 0.7%. A disappointment in Swedish inflation is a surprise, given the inflationary overshoots we are seeing elsewhere. As Sweden is a small, open economy, inflation there will pick up (via imported inflation), which will lift expectations that the Riksbank will normalize policy. 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   Footnotes 1The theory was proposed by Stephen Jen, a former IMF economist and now a hedge fund manager at Eurizon SLJ Capital in London. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle.  Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing.  For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market.    Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle.  Why Now? Chart 7More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9).   Chart 8SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs Chart 12Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21   Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18).  Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio.  Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again.  Chart 21Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. Stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, we expect the 10-year Treasury yield to reach a range of 2% to 2.25% by the end of 2022 when the Fed is ready to lift rates. Maintain below-benchmark portfolio duration. Employment: The static unemployment rate and sub-50 readings from ISM employment indexes will prove to be short-lived phenomena driven by labor supply constraints. These constraints will vanish in the fall when schools re-open and expanded unemployment benefits lapse. Yield Curve: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Feature Last week was another dramatic one in the bond market. Bond yields fell sharply as doubts emerged about the pace of economic recovery and the economy’s progress back to full employment. The 10-year Treasury yield started the week at 1.44% before hitting an intra-day low of 1.25% on Thursday. It then rebounded somewhat to end the week at 1.36%. One catalyst for the move was Tuesday morning’s ISM Non-Manufacturing report that printed at 60.1, below consensus expectations of 63.5. But in truth, economic momentum had already been slowing for several months before that release. The 10-year Treasury yield peaked at 1.74% on March 31st, right around the same time that the New York Fed’s Weekly Economic Index and both the ISM Manufacturing and Non-Manufacturing indexes leveled-off (Chart 1). Last week simply saw the “slowing growth” narrative pick up steam. One noteworthy feature of last week’s market action is that the Treasury curve flattened as yields fell. While the 10-year yield is now at its lowest since February, the 2-year yield remains higher than it was just prior to the June FOMC meeting (Chart 2). This suggests that part of the drop in long-maturity bond yields is due to a fear that the Fed will over-tighten in the face of slowing growth. This fear likely stems from the Fed’s apparent hawkish pivot at the June FOMC meeting.1 Chart 1"Peak Growth" Hits The Bond Market Chart 2A Flatter Curve Since March   It’s also worth mentioning that the bulk of last week’s drop in yields was concentrated in long-maturity real yields (Chart 2, bottom 2 panels). TIPS breakeven inflation rates have fallen somewhat since the end of March. But, at 2.3% and 2.23% respectively, the 10-year and 30-year TIPS breakeven inflation rates are not that far below the Fed’s 2.3% - 2.5% target range. Chart 3Bond Rally Not Confirmed By Commodities Finally, many have suggested that “technical factors” are responsible for last week’s bond market strength. That is, factors related to the supply and demand for bonds but unrelated to economic fundamentals conspired to push yields lower. This is a difficult thesis to prove or disprove, but we will point out that the 10-year Treasury yield has diverged significantly from the CRB Raw Industrials / Gold ratio (Chart 3). The 10-year yield and the CRB/Gold ratio tend to track each other very closely but, in contrast to yields, the CRB/Gold ratio has actually increased since March 31st. This lends some credence to the argument that last week’s drop in yields is not purely a reflection of economic weakness, and it could be an overreaction to weaker-than-expected data that was exacerbated by extreme short positioning in the market (Chart 3, bottom panel). Three Reasons Why The Decline In Treasury Yields Is Overdone We do in fact think that the recent decline in Treasury yields is overdone, and we continue to see the 10-year Treasury yield reaching a range of 2% - 2.25% by the end of next year when the Fed is ready to lift rates. We present three reasons why the recent drop in Treasury yields is overdone. First, the bond market is making too much of the “slowing growth” narrative. Yes, it’s certainly true that the economic indicators shown in Chart 1 are no longer accelerating, but in level terms they remain consistent with a robust economic recovery where GDP growth is well above trend. This sort of growth environment is consistent with a falling unemployment rate that will eventually bring Fed rate hikes into play. Bond yields will move higher as this tightening cycle approaches. Second, it is not just the pace of economic growth that matters for bond yields. The output gap matters as well.2 That is, the same rate of economic growth will coincide with higher bond yields when the unemployment rate is 5% than it will when the unemployment rate is 10%. With that in mind, we observe that the output gap has closed significantly during the past year. The prime-age employment-to-population ratio is 77%, up from a 2020 low of 70%. Similarly, capacity utilization is 75%, up from a 2020 low of 64% (Chart 4). Unless we expect economic growth to slow enough for progress on these two fronts to reverse, then we should see significantly higher bond yields this year compared to last year. This makes it difficult to see how Treasury yields can fall much further from current levels. Another way to conceptualize the relationship between the output gap and long-maturity bond yields is to look at how long-dated yields move relative to short-dated yields. Since the Fed moves the funds rate in response to changes in the output gap, we can model the 10-year Treasury yield relative to the fed funds rate and expectations for near-term changes in the fed funds rate to get a sense of how well the output gap explains changes in long-maturity bond yields. Chart 5 presents a simple model of the 10-year Treasury yield relative to the fed funds rate and the 24-month fed funds discounter. It shows that last week’s decline in the 10-year yield caused it to diverge significantly from the model’s fair value. Chart 4The Output Gap Matters Chart 5Long-Maturity Yields Are Too Low   Third, the Fed’s pledge to keep rates at the zero-lower-bound at least until the labor market reaches “maximum employment” means that the labor market outlook is critical for bond yields. Our view is that the labor market is on the cusp of a rapid recovery that will cause the Fed to lift rates before the end of 2022. However, recent labor market data have been mixed and there is considerable uncertainty in the market about the future pace of employment gains. The next section delves deeper into the outlook for the labor market. Making Sense Of The Employment Data Chart 6ISM Employment Below 50 ... Overall, it seems safe to say that the labor market data have been disappointing in recent months. Yes, nonfarm payroll growth has averaged a robust +543k this year, but the minutes of the June FOMC meeting revealed that “some participants” viewed employment gains as “weaker than they had expected”. The recent dips in the employment components of both the ISM Manufacturing and Non-Manufacturing indexes to below the 50 boom/bust line only add to the sense of pessimism about the labor market. Historically, sub-50 readings from the ISM employment indices (particularly from the non-manufacturing ISM) have coincided with slowing employment growth (Chart 6). This time, however, we don’t see the ISM employment indexes staying below 50 for very long. The more demand-focused components of the ISM indexes – production, new orders and backlog of orders – remain elevated (Chart 7). This tells us that demand is strong and that hiring is only weak because of labor supply constraints, a topic we have covered repeatedly in this publication.3 Our view is that by September, once schools re-open and expanded unemployment benefits lapse, we will see a surge in hiring and a jump in the ISM employment components as people are enticed back into the workforce. A clearer picture of the labor market will then emerge, and it will catalyze a jump in bond yields. It’s not just weak ISM employment readings that are giving investors doubts about the labor market. The unemployment rate’s decline has also slowed markedly in recent months (Chart 8). Our adjusted measure of the U3 unemployment rate currently sits at 6.1%, above the headline U3 measure of 5.9% and significantly above the range of 3.5% to 4.5% that the Fed estimates is consistent with full employment. Chart 7... But Demand Indicators Are Elevated Chart 8Slow Progress On Unemployment Chart 9Labor Supply Is The Problem We adjust the U3 unemployment rate to include a number of people that are currently being classified as “employed but absent from work” when they should be classified as “temporarily unemployed”. The number of people describing themselves as “employed but absent from work” jumped sharply in March 2020 and has remained elevated. This is the result of workers that were placed on temporary furlough during the pandemic and who should be counted as unemployed. We make our adjustment by taking the difference between the number of people that are “employed but absent from work for other reasons” each month and a baseline calculated as that month’s average between 2015 and 2019. We then add this excess amount to the number of temporarily unemployed. This gives us adjusted readings for both the U3 unemployment rate and the temporary unemployment rate (Chart 8, top 2 panels). The Appendix of this report updates our scenarios for the average monthly nonfarm payroll growth required to reach “maximum employment” to consider both this new adjustment and June’s employment figures. Technical adjustments aside, the main takeaway for investors is that progress toward “maximum employment” has been relatively slow during the past few months. This is particularly true if we look at the unemployment rate excluding those on temporary furlough (Chart 8, panel 3) and the labor force participation rate (Chart 8, bottom panel). This slow progress toward “maximum employment” is undoubtedly a reason why bond yields remain low. But, once again, we think it’s only a matter of time before labor supply constraints ease and the unemployment rate falls rapidly, catching up to indicators of labor demand that have already surpassed pre-COVID levels (Chart 9). Bottom Line: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. The labor market also continues to make progress toward maximum employment (and Fed rate hikes) though that progress has slowed during the past few months. We anticipate that stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, the economy will reach full employment in time for the Fed to lift rates in 2022. We expect that the 10-year Treasury yield will be in a range of 2% to 2.25% by then. Maintain below-benchmark portfolio duration. A Quick Note On The Yield Curve Chart 105y5y Still Close To Fair Value While we view the recent drop in the level of bond yields as an overreaction, we are less inclined to view recent curve flattening as temporary. To see why, let’s look at the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate. We like to think of the 5-year/5-year forward Treasury yield as a market proxy for the long-run neutral fed funds rate, so a range of estimates of that rate is a logical fair value target. The 5-year/5-year forward Treasury yield has fallen a lot during the past few weeks. But, at 2%, it is still within the range of neutral rate estimates from the New York Fed’s Survey of Market Participants and only just outside of the same range from the Survey of Primary Dealers (Chart 10). The fact that the 5-year/5-year yield remains relatively close to its fair value range tells us that there is very limited scope for curve steepening. Recent periods of significant curve steepening have tended to coincide with one of the following two developments: The Fed is cutting rates (coincides with a bull-steepening) The 5-year/5-year forward Treasury yield moves into its fair value range after starting out well below it (coincides with a bear-steepening) This second sort of curve steepening occurred during the 2013 taper tantrum, after the 2016 presidential election and again after the 2020 presidential election. It’s conceivable that the yield curve could re-steepen somewhat during the next few months, if the 5-year/5-year forward yield moves back to its prior highs. But we expect the next major move in the Treasury market to be a bear-flattening as the rest of the yield curve catches up to the 5-year/5-year. This is the sort of curve flattening that occurred in 2017 and 2018 when the Fed was lifting rates (Chart 10, bottom 2 panels). A bear-flattening of the yield curve is also the most likely outcome if we start to see significant positive employment surprises later this year, as we anticipate. These employment surprises would bring forward the timing and pace of rate hikes but wouldn’t necessarily cause investors to question their views about the long-run neutral fed funds rate. Bottom Line: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +484k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart helps us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 For a description of the five macro factors that determine bond yields please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019. 3 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021.   Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Feature This week, we present the BCA Central Bank Monitor Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions in developed market countries. The surging Monitors are all sending a similar message: tighter global monetary policy is necessary because of above-trend economic growth, intensifying inflation pressur­­es and booming financial markets (Charts 1A & 1B). Chart 1ATightening Pressures … Chart 1B… Everywhere The Monitors are pointing to a continuation of the cyclical rise in global bond yields seen since mid-2020, justifying our recommended below-benchmark stance on overall duration exposure in global bond portfolios. The driver of the next leg upward in yields, however, is shifting from growth and inflation expectations to monetary policy expectations. The Fed is starting to slowly prepare markets for the next US tightening cycle, which is already putting flattening pressure on the US Treasury curve and creating more two-way risk for the US dollar over the next 6-12 months. The timing and pace of rate hikes discounted by markets varies across countries, however, creating interesting opportunities for currency pairs, via changing interest rate differentials, away from the US dollar crosses. An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data which have historically been correlated to changes in monetary policy. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure similar things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors. We have constructed Monitors for ten developed market countries: the US, the euro area, the UK, Japan, Canada, Australia, New Zealand, Sweden, Switzerland and Norway. A rising trend for each Monitor indicates growing pressures for central banks to tighten policy, and vice versa. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators (equity prices, corporate credit spreads, etc). The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates. Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar. We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Chart 2AThe Surging CB Monitors …. Chart 2B… Suggest More Upside For Bond Yields In each edition of the Central Bank Monitor Chartbook, we include a “non-standard” chart that shows an interesting correlation between the Monitors and a financial market variable. In this latest report, we show how the relationship between the Monitors and our 24-Month Discounters, which measure that amount of rate hikes/cuts discounted in overnight index swap (OIS) forward curves over the next two years. We have also added a new Appendix Table that shows the so-called “liftoff dates” (the date when a first full rate hike is discounted in OIS curves), the cumulative amount of rate hikes expected to the end of 2024, and the valuation of each country’s currency on a purchasing power parity (PPP) basis. We’ve ranked the countries in the table by liftoff dates, thus providing a handy reference to see how markets are judging the order with which central banks will begin the next monetary policy tightening cycle. Fed Monitor: A Clear Signal Our Fed Monitor has been climbing steadily, uninterrupted, for 13 consecutive months, driven by the combination of strong US growth, sharply higher inflation and booming financial markets (Chart 3A). The message from the highly elevated level of the indicator is clear – the Fed should begin the process of unwinding the massive monetary policy accomodation put in place because of the COVID-19 pandemic. At this week’s FOMC meeting, the Fed delivered a mildly hawkish surprise by pulling forward the projected timing of “liftoff” (the first fed funds rate hike) from 2024 to 2023. The timing and pace of future Fed tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the Fed’s definition of “maximum employment”. We see that happening by the end of 2022, which is a bit ahead of the Fed’s own projections for the unemployment rate. The US OIS curve now discounts liftoff near the end of 2022 (see Appendix Table 1), which is now more in line with our own view that the Fed will begin tapering next January and begin rate hikes in December 20221. US economic growth momentum has likely peaked in Q2, but will remain solid in the latter half of 2021. Most of the nation has lifted the remaining pandemic restrictions on activity after a succesful vaccination program, and fiscal policy is still providing a boost to growth. The Fed’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. The Fed’s assumption is trend GDP growth is still only 1.8%, thus the central bank now expects three consecutive years of above-trend growth. Unsurprisingly, the Fed is forecasting headline PCE inflation to stay above the Fed’s 2% target for all three years (Chart 3B). Chart 3AUS: Fed Monitor Chart 3BIs This Really 'Transitory' Inflation? The recovery in the Fed Monitor has been led primarily by the growth component, although the inflation and financial components have also risen significantly (Chart 3C). The Fed Monitor has typically been negatively correlated to the momentum of the US dollar, which has always been more of a counter-cyclical currency that weakens in good economic times. A more hawkish path for US interest rates could eventually give a sustainable lift to the greenback, but for now, the currency will be caught in a tug of war between shifting Fed expectations and robust global growth over the next 6-12 months. Chart 3CBooming Growth Supporting USD Weakness We continue to recommend an underweight strategic allocation to US Treasuries within global government bond portfolios, with markets still pricing in a pace of Fed tightening that appears too conservative (Chart 3D). Chart 3DNot Enough Fed Rate Hikes Priced The Fed’s mildly hawkish surprise this week generated a signficant flattening of the US Treasury curve, with the spread between 5-year and 30-year US yields narrowing by a whopping 20bps. We are closing our two recommeded yield curve trades in the BCA Research Global Fixed Income Strategy tactical trade portfolio, which were positioned more to earn near-term carry in a stable curve environment that has now changed with the Fed injecting volatility back into the bond market. BoE Monitor: More Hawkish Surprises Coming Our Bank of England (BoE) Monitor has spiked higher, fueled by a rapid recovery of UK growth alongside a pickup in inflation pressures (Chart 4A). The BoE has already responded by slowing the pace of its asset purchases in May, and we expect more tapering announcements over the next 6-12 months. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 4B). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. Chart 4AUK: BoE Monitor Chart 4BUpside UK Inflation Surprises Ahead? The recent decision by the UK government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant represents a potential near-term setback to UK growth momentum. The bigger picture, however, still points to an economy benefitting far more from the earlier success of the vaccination program. Consumer confidence remains resilient, while business confidence – and investment intentions – has taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. The backdrop still remains one of above-potential UK growth over the next 12-24 months. Within the BoE Monitor sub-components, the economic and financial elements stand out as having the biggest moves over the past year (Chart 4C). Momentum in the British pound is positively correlated to our BoE Monitor. As the central bank moves incrementally moves towards more tapering and eventual rate hikes, the currency, which remains moderately undervalued on a PPP basis (see Appendix Table 1), should be well supported. Chart 4CAll BoE Monitor Components Are Rising The UK OIS curve currently discounts BoE liftoff in May 2023, with 57bps of cumulative rate hikes expected by the end of 2024. We see risks of the central bank moving sooner than the market on liftoff, with a rate hike in the 3rd or 4th quarter of 2022 more likely. The Gilt market is vulnerable to any hawkish shift by the BoE with so few rate hikes discounted (Chart 4D). For now, we are maintaining a neutral stance on UK Gilts, given the BoE’s history of talking hawkishly but failing to deliver, but we do have them on “downgrade watch.” Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Growth? Yes. Inflation? No. Our European Central Bank (ECB) Monitor has moved sharply higher as more of the euro area has emerged from pandemic restrictions (Chart 5A). Yet the central bank is not sending any of the kinds of moderately hawkish signals coming from the Fed and other central banks. The ECB is still a long way from such a move. While growth has clearly recovered strongly, the overall euro area unemployment rate remains high at 8% and wage growth remains anemic in most countries. There is the potential for upside growth surprises coming from fiscal policy, with the Next Generation EU (NGEU) funds set to be disributed by the EU later this year. Yet even with this fiscal boost, most of the euro area is likely to remain far enough away from full employment allowing the ECB to stay dovish for longer. While headine euro area inflation reached the ECB’s 2% target in May, core inflaton remained subdued at a mere 0.9% (Chart 5B). Market based measures of inflation expectations are also well below the ECB target, with the 5-year/5-year forward CPI swap rate only at 1.6%. Such “boring” inflation readings – even after a surge in commodity price fueled inflation in many other countries – proves that there remains ample spare capacity in the euro area economy and labor markets. The ECB is under no pressure to turn less dovish anytime soon. Chart 5AEuro Area: ECB Monitor Chart 5BStill Lots Of Spare Capacity In Europe The lack of an immediate inflation threat can also be seen in the sub-components of our ECB Monitor, where the inflation elements have clearly lagged the growth upturn (Chart 5C). From a currency perspective, a growth fueled surge in the ECB Monitor is usually enough to provide a boost to the euro. Yet, without an inflation trigger, the likelihood of the ECB dialing back bond purchases, let alone raising interest rates, is low. This suggests any rally in the euro from current levels will be a slow adjustment towards fair value. Chart 5CInflation Components Lagging Currently, the European OIS curve is discounting an initial ECB rate hike in October 2023, with only 27bps of rate hikes expected by the end of 2024 - one of the most dovish pricings in the G10 (see Appendix Table 1). Even though our ECB Monitor suggests that European bond markets should be pricing in more rate hikes (Chart 5D), that is unlikely to happen with the ECB messaging a dovish stance and with the central bank set to release a review of its inflation strategy later this year. We continue to recommend an overweight stance on European government bonds within global fixed income portfolios. Chart 5DMarkets Hear The ECB's Dovish Message   BoJ Monitor: Deflation Is Still A Threat Our Bank of Japan (BoJ) Monitor has recovered from deeply depressed pandemic lows to just above the zero line (Chart 6A). This is welcome news for the BoJ, that kept interest rates and asset purchases unchanged at yesterday's meeting, but recognized the need for additional stimulus via "green" loans.The reading from the central bank monitor is also consistent with a Japanese economy that requires more accommodative monetary policy vis-à-vis the rest of the G10. The Japanese economy remains under siege from the pandemic. The number of new COVID-19 cases remains at the highest level per capita in developed Asia. Meanwhile, the manufacturing PMI is the lowest in the developed world and a third wave of infections has also crippled the services sector. This pins the Japanese recovery well behind that of other G10 countries. The IMF expects the output gap in Japan to close sometime in 2023, but it is worth noting that there are few signs of inflationary pressures that would signal such an outcome. Both core and headline Japanese prices are deflating in a world where the risks are tilted towards an inflation overshoot (Chart 6B). The unemployment rate has rolled over, but still remains a ways from pre-pandemic lows. Savings in Japan are also surging, short-circuiting the sort of positive feedback loop that will generate genuine inflation. Chart 6AThe BoJ Monitor Chart 6BDeflation Is Still A Threat In Japan The individual elements of the BoJ Monitor suggest that the growth component has seen steady improvement over the last few months, while the financial component has rolled over (Chart 6C). The latter reflects the underperformance of Japanese equities in recent months, after a spectacular rally late last year. However, weakness in the yen has also allowed financial conditions to remain relatively easy. The yen is a safe-haven currency, making the relationship with the central bank monitor less intuitive. When the central bank monitor is improving (both in Japan and globally), traders tend to use the yen to fund carry trades elsewhere, which weakens the currency. When risk aversion sets in, these trades are unwound, and the yen rallies. This year, the yen has weakened in sympathy with improving global growth, suggesting this playbook remains very much relevant. Chart 6CModest Improvement In The Growth And Inflation Components The strength of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should rise towards the upper bound of the -25bps to +25bps band. However, the BoJ will stand firm in maintaining easy monetary policy, as expected by market participants (Chart 6D). This policy-induced stability makes JGBs a defensive bond market when US Treasury yields are rising, a key reason for our overweight stance on JGBs. Chart 6DNo Change In Policy Expected BoC Monitor: Strong Growth = Early Tightening Our Bank of Canada (BoC) Monitor has shown an impressive rebound and currently displays the highest figure among our Central Bank Monitors (Chart 7A). With a growing number of central banks contemplating a less dovish turn, Canada will be in the group of developed countries that hikes policy rates first. The Canadian economy started the year gaining significant positive momentum, with Q1 GDP growing by +5.6% (annualized quarter-on-quarter rate of change). The Q2 picture is a bit more mixed because of another wave of COVID-19 lockdowns. However, thanks to the rapid improvement in the pace of vaccinations after a botched initial rollout, Canadian household consumption and confidence have notably accelerated. Business confidence and investment intentions have also picked up solidly according the BoC’s most recent Business Outlook Survey. The job market also gained significant momentum, and as the lockdown measures gradually ease, workers who have been laid off during the pandemic will return to work. Therefore, the improvement in labor market will continue. A rapidly closing output gap means that the current surge in inflation may endure after the base effect comparisons to 2020 fade (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BCanadian Inflation Pressures Intensifying Looking at the components of our BoC Monitor, all three factors have clearly rebounded but the growth factor has shown the most impressive move (Chart 7C). Amid the broad economic factors that have improved, booming house prices – a primary cause for the BoC’s decision to taper its asset purchases back in April - have caused the growth factor to rebound quickly. Chart 7CA Positive Story For The CAD The Canadian OIS curve is pricing in BoC liftoff in August 2022 (Appendix Table 1), with a sooner liftoff only expected in Norway and New Zealand. We see risks that the BoC moves much sooner than that next year. A quicker liftoff which will put additional upward pressure on the Canadian dollar, both against the US dollar and on a trade-weighted basis, particularly if Canadian export demand remains solid and oil prices continue to climb, as our commodity strategists expect. Our PPP model suggests that the Loonie is close to fair value, so valuation is not yet an impediment to additional strength in the Canadian dollar. Looking at the longer-term horizon, the OIS curve is discounting four BoC rate hikes within the next 24 months, and it is not clear that will be enough to cool off the red-hot Canadian housing market – currently the biggest threat to inflation stability in Canada (Chart 7D). Given that relatively hawkish view, the more optimistic growth outlook, and the high-beta status of Canadian government bonds, we continue to recommend an underweight position on Canadian government bonds within a global fixed income portfolio. Chart 7DCanadian Rate Expectations Look Fairly Priced RBA Monitor: Waiting For Inflation Our Reserve Bank of Australia (RBA) Monitor has continued its strong rebound since the trough in 2020 and is now at all-time highs, suggesting heightened pressure on the RBA to tighten policy (Chart 8A). This rebound comes amid dovish messaging from an RBA that is waiting on signs of an inflation turnaround. The RBA’s patience makes sense when you consider measures of slack in the economy, such as output and unemployment gaps (Chart 8B). While the IMF does expect the output gap to tighten up significantly in 2021, it does not expect it to be closed even by 2022. Looking to capacity in the labor market, the unemployment rate has just returned to pre-COVID levels. However, the labor market will need to run “hot” for a sustained period of time to push up wage inflation, which remains deep in the doldrums according to the RBA’s wage price index. Chart 8AAustralia: RBA Monitor Chart 8BMuted Inflationary Pressures Down Under A look at the components of our RBA Monitor explains the RBA’s dovishness in the face of the tightening pressure indicated by the “headline” figure (Chart 8C). The rebound in the Monitor can be attributed almost entirely to the growth and financial components, which are driven in turn by improving confidence and an expanding RBA balance sheet. However, the inflation component, which has barely budged off its 2020 low, best captures the metrics that the RBA is watching. Importantly, the RBA will need to see sustainable domestically-generated inflation before it can begin to tolerate a stronger AUD which would otherwise imperil tradable goods inflation. With the AUD only slightly expensive on our PPP models, the RBA does not have much of a “valuation cushion” to play with in terms of delivering a hawkish surprise (Appendix Table 1). ​​​​​​ Chart 8CGrowth Factors Are Driving the RBA Monitor Chart 8D shows that market pricing for hikes over the next two years has remained mostly flat in 2021 in the face of persistently dovish messaging from the RBA. Our view, as expressed in a recent update of our “RBA checklist”2, is that fundamental factors will force the RBA to remain dovish, making Australian government debt an attractive overweight within global government bond portfolios. Chart 8DMarkets Are (Rightly) Looking Through Tightening Pressures In Australia RBNZ Monitor: Heating Up Our Reserve Bank of New Zealand (RBNZ) Monitor has rebounded to levels last seen in 2017, largely on the back of improving growth (Chart 9A). Success at containing the virus has allowed the New Zealand economy to beat growth expectations for Q1/2021, effectively pulling forward future policy tightening. Measures of capacity utilization in New Zealand will likely respond accordingly to improved growth prospects, with the output gap likely to close even faster than projected by the IMF (Chart 9B). Measures of core and headline inflation remain within the RBNZ’s 1-3% target range, with the Bank expecting headline inflation to shoot up to 2.6% in Q2/2021 before settling around the midpoint of the range. Chart 9ANew Zealand: RBNZ Monitor Chart 9BThe New Zealand Economy Is Quickly Working Off Slack Looking at the individual components of our RBNZ Monitor, the rebound in the overall indicator is clearly a growth story (Chart 9C). This component of our Monitor also captures the effect of accelerating house prices, which have become a direct concern for RBNZ policy. According to the bank’s own projections, house prices will post a whopping 29% growth rate in the second quarter. With issues of housing affordability at the forefront, and political pressure mounting, the RBNZ will likely be forced to turn less dovish soon, even if it comes with unwanted strength in the NZD. However, the currency is among the most expensive on our PPP models (Appendix Table 1), which means that a reversion to fair value could counteract upward pressure from a hawkish RBNZ. Chart 9CThe RBNZ Will Do Whatever It Takes To Stabilize House Prices Historically, our RBNZ Monitor has correlated well with market pricing embedded in the OIS curve (Chart 9D). In 2021, however, market expectations have far outstripped the signal from our central bank monitor, meaning that markets believe the RBNZ is more focused on growth factors rather than the overall picture, a view that we largely agree with. Chart 9DMarkets Expect A Hawkish RBNZ Even after the Fed’s hawkish surprise at this week’s meeting, we still believe that the RBNZ will be among the first to taper its balance sheet and move towards normalizing policy. Stay underweight New Zealand sovereign debt. Riksbank Monitor: Watch For An Upside Surprise Our Riksbank Monitor has posted a strong rebound, reaching all-time highs (Chart 10A). This rebound has come on the back of a robust economic recovery. Meanwhile, monetary policy has been accommodative with the Riksbank holding the repo rate at 0% while expanding the size of its balance sheet. Capacity utilization, which in Sweden did not fall nearly as much as in other developed economies, is looking set to recover in the coming years (Chart 10B). Although headline CPI shot past the 2% target, driven by fuel and food prices, underlying core inflation remains stable. The Riksbank expects inflation to fall due to less favorable year-over-year base effects, and only sustainably climb to the 2% level by mid-2024. Chart 10ASweden: Riksbank Monitor Chart 10BThe Rise In Swedish Inflation Is 'Transitory'... Breaking down the rise in the Riksbank Monitor, we can see that it is driven overwhelmingly by the growth component (Chart 10C). This, in turn, has been driven by surging PMIs and soaring business and consumer confidence. Our colleagues at BCA Research European Investment Strategy have pointed out that the small export-sensitive economy will be poised to benefit from an upturn in the global industrial cycle3. While Sweden did arguably botch its COVID-19 response last year, it is catching up, with 42% of Swedes having already received their first dose of the vaccine. The case for the SEK is strong, given that the currency is a high-beta play on global growth and is also quite undervalued according to our PPP models (Appendix Table 1). Market expectations are that the Riksbank will lag others in normalizing policy, putting off a hike until September 2023. The Riksbank baseline is a flat repo rate out to Q2/2024 but an earlier rate hike is well within the “uncertainty bands” of the Riksbank’s forecast. Such a scenario may manifest if growth and inflation surprise to the upside. Chart 10C...But The Riksbank Cannot Ignore Explosive Growth Given the positive economic backdrop and the financial stability risks posed by rising house prices and household indebtedness, we believe market pricing is too dovish relative to the actual pressure on the Riksbank to tighten policy (Chart 10D). This makes Swedish sovereign debt an attractive underweight candidate in global government bond portfolios. Chart 10DThe OIS Curve Is Pricing In Too Much Dovishness From The Riksbank Norges Bank Monitor: The First To Hike Our Norges Bank Monitor has risen sharply from the pandemic lows and now signals that emergency monetary settings are no longer appropriate for the Norwegian economy (Chart 11A). Consistent with this message, Norges Bank governor, Øystein Olsen, suggested this week that a rate hike will occur in September, with possibly another hike by December of this year. Norway has handled the pandemic successfully. Since the onset of the COVID-19 crisis, it has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was also prompt and finely tailored to the sectors most in need of emergency funds. Moreover, monetary policy was highly accommodative, with the Norges Bank cutting interest rates to zero for the first time since its founding in 1816. Fiscal stimulus will remain relatively accommodative, as Norway will register one of the smallest fiscal drags in the G10 for the remainder of 2021 and 2022. Rapid improvement in the labor market also continues. After peaking at 9.5% in March 2020, the headline unemployment rate has fallen to 3.3%. On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024. These developments have set the Norwegian economy on a sustainable recovery path. This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3% (Chart 11B). Meanwhile, while core inflation at 2% is decelerating, the slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mindset has not taken root in Norway. Chart 11AThe Norges Bank Monitor Chart 11BInflation Is Well Anchored In Norway The biggest improvement in our Norges Bank Monitor comes from its growth and inflation components, the former surging to its highest level in two decades. This improvement surpasses those that followed the global financial crisis and the bursting of the dot-com bubble (Chart 11C). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. The Monitor shows a very tight correlation with the trade-weighted currency, suggesting the exchange rate is an important valve for adjusting financial conditions. As an oil-producing economy, the drop in the NOK cushioned the crash in oil prices last year. This year, a recovery has benefitted the krone. The Norwegian krone also remains undervalued according to our PPP models. Chart 11CThe Norges Bank Should Hike Rates A positive correlation also exists between the Monitor and expected rate hikes by the Norges bank (Chart 11D). This suggest yields in Norway should either coincide or lead the improvement in global bond yields. From a portfolio perspective, our default stance is neutral, as the market is thinly traded. Chart 11DThe Norges Bank Should Hike Rates SNB Monitor: Green Shoots Our Swiss National Bank (SNB) Monitor has recovered smartly, and is at the highest level in over a decade (Chart 12A). This is a marked turnaround for a country that has had negative interest rates since 2015. It also raises the prospect that Switzerland may be finally able to escape its liquidity trap, allowing the SNB to modestly adjust monetary policy upward. The Swiss economy has recovered swiftly. As of May, the manufacturing PMI was at 69.9, the highest reading since the start of the series. If past manufacturing sentiment is prologue, the Swiss economy is about to experience its biggest rebound in decades. This will quell any deflationary fears about domestic conditions in Switzerland and begin to re-anchor inflation expectations upwards. This will also be a very welcome development for the SNB. Inflation dynamics in Switzerland will be particularly beholden to improvements in private sector demand. The unemployment rate in Switzerland has rolled over, which should begin to provide an anchor to wage growth. Both core and headline inflation are also recovering, albeit at a slow pace (Chart 12B). Import prices in Switzerland will also rise, driven by the relative weakness of the currency. This is important because for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Chart 12AThe SNB Monitor Chart 12BSwiss Inflation Not Out Of The Woods Looking at the components of our SNB Monitor, the growth component has been in the driver’s seat (Chart 12C). But encouragingly, both the inflation and financial component have also been grinding higher. This improvement suggests that the weakness in the franc, especially amidst global dollar weakness, has been a welcome jolt to the economy. Like the yen, the CHF is a safe-haven currency, making the relationship with the central bank monitor less intuitive. Most of the time, the relationship with the monitor is inverse, corresponding to investors using the Swiss franc for carry trades when global conditions improve. Similar to the yen this year, the CHF has also weakened in sympathy with improving global growth. Should global growth see a setback in the near term, the franc will benefit. Chart 12CGrowth Indicators Are Surging In Switzerland The SNB Monitor is more accurate at capturing expected policy changes by the SNB. This means that yields in Switzerland could see more meaningful upside (Chart 12D). That said, our default stance on Swiss bonds is neutral in a global portfolio, given low liquidity. Chart 12DCould The SNB Finally Lift Rates? Appendix Table 1 Table 1Appendix Table 1 Footnotes 1 See BCA Research US Bond Strategy/Global Fixed Income Strategy Special Report, “A Central Bank Timeline For The Next Two Years”, dated June 1, 2021, available at gfis.bcaresearch.com 2 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research European Investment Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcaresearch.com.

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Chart 14Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Section III: Geopolitical Calendar