Financial Markets

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

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Chart 2Global Manufacturers' Prices Moving Higher These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View Chart 8Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Chart 10Wider Vaccine Distribution Will Support Gold Demand Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Chart 12 Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights As commodity inflation subsides, so will broader inflation. As broader inflation subsides, so will inflation expectations – because inflation expectations just follow realised inflation. Overweight US T-bonds versus TIPS. Overweight UK gilts versus index-linked gilts. Within equities, sell the reflation trades: specifically, go underweight basic materials and industrials. Underweight commodity currencies, such as the Canadian dollar, South African rand, and Norwegian krone. Fractal trade shortlist: ZAR/USD, HUF/USD, AMC Entertainment. Feature Chart of the WeekThe Inflation Bubble Will Burst In the past few weeks, most commodity prices have undergone healthy corrections. Relative to recent peaks, the lumber price has plunged by 30 percent, while wheat, iron ore, and DRAM (semiconductor) prices are almost 15 percent lower. The price of copper, together with other industrial metals, is also down, albeit by a more modest 5 percent (Chart I-2). Chart I-2Most Commodity Prices Have Corrected Oil is the only major commodity that has not corrected (yet), but even here, the 1-year inflation rate has plummeted. This is highly significant, as the oil inflation rate feeds straight into the headline CPI inflation rate. Hence, we can say with reasonable conviction that the inflation bubble will soon burst (Chart I-1). What drove the spike in inflation? The answer is that as industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities and services led to understandable surges in their prices. These price surges unleashed fears about inflation, causing investors to pile into inflation hedges. This drove up commodity prices further and more broadly… which added to the inflation fears…which added more fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The indiscriminate rally in commodity prices is ending. But supply bottlenecks eventually ease, at which point the price spike corrects – in some cases violently – and the indiscriminate rally in commodity prices ends. This is what we are witnessing now. As commodity inflation subsides, so will broader inflation. And as inflation subsides, so will inflation expectations – because inflation expectations just follow realised inflation. The Markets Are Lousy At Predicting Inflation We now come to a profound question. Why do inflation expectations just follow realised inflation? (Chart I-3) After all, the chances are low that inflation in the future will be the same as it was in the past (Chart I-4). Chart I-3Inflation Expectations Just Follow Realised Inflation Chart I-4AThe Markets Are Lousy At Predicting Inflation Chart I-4BThe Markets Are Lousy At Predicting Inflation The answer comes from our insensitivity to changes in low inflation rates. We cannot perceive changes in the broad inflation rate between -1 and 3 percent, a range we just perceive as ‘price stability’. For example, if a loaf of bread costs £1.50 today, most people cannot perceive the difference between it costing £1.44 two years ago (2 percent inflation) or £1.47 pence (1 percent inflation). Quality improvements compound the perception difficulty. If the loaf used to cost £1.47 pence but the ingredients and nutritional quality are 5 percent better today, then the quality-adjusted price has gone down. The inflation rate is -1 percent! Inflation rates within a low range just feel the same to us, so it is impossible to fine-tune our inflation expectations. As inflation rates within a low range just feel the same to us, it is impossible to fine-tune our inflation expectations. Therefore, when asked to quantify our inflation expectation, we just anchor on the latest realised number. Which explains why inflation expectations just follow realised inflation. Unfortunately, central banks persist in thinking of inflation as a linear phenomenon which they can nail to one decimal place, as if the decimal point means something! But, to repeat, we cannot perceive much difference between low rates of inflation. The entire range of low inflation just feels like price stability. Therefore, within this range, our behaviour stays unchanged. And if our behaviour is unchanged, what is the transmission mechanism to fine-tune inflation within the -1 to 3 percent range? In fact, inflation is a non-linear phenomenon, with two phases: price stability and price instability. Hence, policymakers can undoubtedly take an economy from price stability into price instability – and often do, as witnessed recently in Argentina, Venezuela, and Turkey (Chart I-5). Chart I-5The Choice Is Price Stability Or Price Instability But if a major developed economy tried to take the road to price instability, the ensuing collapse in asset prices would unleash a massive deflationary impulse, as we explained in The Road To Inflation Ends At Deflation. Time To Sell The Reflation Trades Our insensitivity to small changes in low inflation rates contrasts with our very finely-tuned sensation of changes in low nominal interest rates. For example, if your UK floating mortgage rate was tied to the Bank of England policy rate, and the Bank hiked the policy rate to 0.25 percent, your monthly mortgage payment would double. Which would really hurt!1  Contrast this with an alternative situation in which the UK inflation rate fell by 0.25 percent from, say, 0.1 percent to -0.15 percent. In this case, the real interest rate would double. Yet you would barely notice it. Proving again that changes in low inflation rates are imperceptible. All of this has important implications for how we should interpret real interest rates. An ex-post (historical) real interest rates is reliable because it is the true historical nominal interest less the true historical inflation rate. However, an ex-ante (expected) real interest rate is unreliable because it is the true prospective nominal interest less the predicted inflation rate. The problem is that the predicted inflation rate will almost certainly turn out to be wrong. Inflation expectations are too high. In short, if commodity inflation is rolling over, then inflation expectations are too high. The upshot is that the ex-ante real interest rate, as priced by Treasury Inflation Protected Securities (TIPS) and UK index-linked gilt yields is too low – at least, relative to nominal yields. Which leads to the following investment conclusions: 1. Overweight US T-bonds versus TIPS. 2. Overweight UK gilts versus index-linked gilts. 3. Within equities, it is time to sell the reflation trades: specifically, go underweight basic materials and industrials – which are just a proxy for inflation expectations (Chart I-6). Chart I-6Basic Materials And Industrials Are Just Tracking Inflation Expectations 4. Underweight commodity currencies, such as the Canadian dollar, South African rand, and Norwegian krone. In fact, CAD/USD is just a very tight play on inflation expectations. Nothing more, nothing less (Chart I-7). Moreover, the fragile fractal structures for CAD/USD and ZAR/USD confirm that both commodity currencies are vulnerable to correction (Chart I-8). Chart I-7CAD/USD Is Just Tracking Inflation Expectations Chart I-8ZAR/USD Is Vulnerable To Correction 5. In addition, HUF/USD is also vulnerable to correction given that a sharper rise in Hungarian inflation expectations have already driven up the currency cross (Chart I-9). A recommended trade is to short HUF/USD, setting the profit target and symmetrical stop-loss at 3 percent. Chart I-9HUF/USD Is Vulnerable To Correction Fractal Analysis Of ‘Meme’ Stocks Finally, several clients have asked if the use of fractal analysis can be extended from indexes and asset-classes to individual stocks. The answer is an emphatic yes. Fractal analysis works by identifying when the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. At this point, as longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. Eventually though, when the longer-term investors re-enter the price setting process, the price snaps back towards the valuation anchor. This makes fractal analysis particularly suitable for identifying when ‘meme’ stock rallies – fuelled by aggressive trend-following – are most susceptible to correct. Right now, the recent 700 percent rally in the meme stock, AMC Entertainment, is at such a point of vulnerability (Chart I-10). Chart I-10AMC Entertainment's Aggressive Rally Is At A Point Of Vulnerability On this basis, a recommended trade is to short AMC, setting the profit target and symmetrical stop-loss at 100 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 In this illustrative example, we assume that the mortgage rate equals the base rate plus 0.1 percent. Hence, if the base rate rose from 0.1 percent to 0.25 percent, the mortgage rate would rise from 0.2 percent to 0.35 percent, a near doubling. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The Fed’s independence from politics is illusory. President Biden has the potential to reshape the Fed’s Board of Governors through three personnel picks, two of which are due by January 2022. While monetary policy could only get marginally more dovish, the Democratic Party’s goals would be furthered by new appointments. If Biden retains Powell then he is convinced that Powell is fully committed to today’s ultra-dovish monetary policy strategy. If he does not, then the new Fed chair will be still more dovish. Nevertheless the excessive expansion of the US money supply is reminiscent of the Arthur Burns era and suggests that any Fed chair faces a sea of troubles from 2022-26. For now stay long TIPS, infrastructure plays, cyclicals, and value stocks. Feature I do not recall a single instance where somebody in the political realm said, “We need to raise rates, they’re too low.”                         -Alan Greenspan, CNBC, October 18, 2018 Just before the 2020 election I held a call with a client in New York and the question arose of whether the expected winner, then candidate Joe Biden, would reappoint Federal Reserve Chairman Jerome Powell when his term expired on January 31, 2022. I argued that the odds of Biden keeping Powell in place were higher than one might think. After all, Powell reversed his stance on rate hikes in the winter of 2018-19 and then oversaw the Fed’s adoption of a new monetary policy strategy that deliberately targets an inflation overshoot. Powell would be a reliable dove for a president who would seek economic recovery above all things. The client drily responded, “There is no way that is going to happen.”   We still do not know what President Biden will decide with seven months before the decision is due. Personnel appointments are a matter of information and intelligence, not political or macroeconomic analysis. From a macro point of view all that can be said is that Biden does not face the situation President Trump faced: Biden has entered early in the business cycle, under a new, ultra-easy average inflation targeting regime at the Fed. Trump entered in the middle of a business cycle, while the Fed was hiking rates (Chart 1). Chart 1Biden's and Powell's Context Almost any new Fed chair will be largely constrained by the policy consensus on the Federal Open Market Committee (FOMC). Biden is an establishment player whose appointments so far suggest that he is unlikely to nominate a maverick capable of bucking the entire FOMC. But personalities can still make a difference at critical junctures. Nobody should be surprised if Biden opts to replace Powell with a candidate who is marginally more committed to keeping rates lower for longer.   Investors should bet on dovish surprises for three reasons. First, the Fed as an institution has reached a consensus on its current policy framework, which is geared toward an inflation overshoot. Second, Powell may wish to retain his job. Third, the aforementioned client could be right and Biden may replace Powell with a more fervent proponent of ultra-easy policy. The takeaway is bullish for the time being. The Dependency Of Central Banks Central banks are part of the political bureaucracy of the nation state. Insofar as they achieve policy autonomy, or independence, it is at the forbearance of the executive or legislative branch. The ability to contain personal influences shows institutional maturity but institutions can never be fully independent. Fiscal policy is controlled by the ruling party, which will legislate in its interest. The “political business cycle” is an empirical phenomenon in which policymakers attempt to manipulate fiscal policy ahead of elections either to help or hurt the incumbent. A “political monetary cycle” also exists but its prevalence is debatable. It is more widely observed in developing countries.1 Politics in the developed world are more democratic and institutionalized so central banks have achieved considerable autonomy. In many cases their independence is enshrined in law, although the legal basis is often questionable and exaggerated.2  Not only are there checks and balances but they are reinforced by asynchronous cycles between the institutions. Term limits constrict politicians as much as or more so than monetary policymakers. Federal Reserve chairmen William McChesney Martin, Arthur F. Burns, and Jerome H. Powell were not immune to political influence but were able in their own ways to “wait out” the tenure of manipulative presidents Lyndon B. Johnson, Richard M. Nixon, and Donald J. Trump. Still, the latter examples highlight that developed markets cannot claim to be purely rationalist in their conduct of monetary policy. President Trump publicly asked, “Who is our bigger enemy, Jay Powell or Chairman Xi?” Yet this was mild compared to the treatment that Nixon gave Burns and especially that Johnson gave Martin. Johnson physically shoved Martin around a private room demanding policy easing and accused him of not caring about the lives of young American soldiers dying in Vietnam. Martin held his ground and hiked rates in 1966 despite the war.3 Arthur Burns was subjected to a relentless campaign of public and private verbal abuse by Nixon and his staffers. Nixon was convinced that he lost the 1960 election because of overly tight Fed policies and was determined not to let it happen again in 1972. Greenspan kept rates low during the Iraq war and inflated the housing bubble. Plenty of unsavory examples of political influence and interference can be drawn from other developed markets.4 All governments and monetary systems are built and run by humans and therefore fallible. Even aside from individuals and anecdotes, structural forms of central bank manipulation within the developed world include: (1)  Debt accommodation: Central banks face an inexorable pressure to provide liquidity to governments running irresponsible fiscal deficits. The consequences if they refused could be devastating (Chart 2). Chart 2The Fed's Biggest Political Constraint: Debt (2)  Appointments: Presidents and executives appoint and remove leaders. In the US, the tendency for members of the Board of Governors to resign often gives the president substantial influence even aside from picking the Fed chairman, who can indeed be removed at will.5 (3)  Bureaucracy: Administrative structures exert a powerful influence over the personnel, policy frameworks, and behavior of central bank leadership and staff. The candidates for top positions are heavily filtered – and once they achieve high office, their options are constrained.6 Today’s Federal Reserve supports these three points: it is highly accommodative toward the US’s soaring federal debt and its leadership consists of a tight coterie of experts and academics who share a robust consensus regarding the appropriate theory and practice of monetary policy. The outstanding question stems from item number two, appointments, where President Biden has the opportunity to influence the Fed’s board. But the third point mostly controls the available personnel. Still, the choice of the Fed chair could prove decisive under unforeseen circumstances. Historical accounts of the Fed show that the chairman exerts substantial influence over monetary policy decisions.7 Most investors know from experience that individuals and leaders can still exert an outsized influence at critical junctures. For example, premature monetary tightening occurred with negative consequences in the US in 1937, Japan in 2000, and Europe in 2011. Investors are safest to bet on institutions rather than individuals. But the choice of the Fed chair can hardly be ignored. The current context features an extraordinary expansion of the money supply, and “excess money supply,” comparable only to the inflationary 1970s (Chart 3). The Fed chair in the coming years faces an unstable and difficult sea of troubles to navigate.  Chart 3Excess Money Supply Unseen In Modern Memory Fed Chairs Care About Their Careers But Not Midterm Elections Political influence over monetary policy is measurable. A substantial body of academic literature reveals not only the above structural political factors but also that ideological affiliation – i.e. the political party whose president appointed the Fed chair – influences interest rates. So do elections and the career interests of Fed chairmen. Consider the following findings:  Abrams and Iossifov show evidence of abnormally expansionary monetary policy if the president and the chair are affiliated with the same political party.8 Gamber and Hakes show evidence of a lowered federal funds rate if the Fed chair stands for reappointment in the two years following a national election – i.e. Fed chairmen accommodate political pressures in the latter part of term to increase odds of reappointment.9 Dentler shows that while the Fed funds rate does not fall in advance of elections to help presidents in general, it is found to fall when the Fed chair and president have the same partisan affiliation, especially when the Fed chair’s reappointment is looming. Also the Fed funds rate is abnormally high before elections if the Fed chair hails from the opposite party of the incumbent president.10 Dentler shows specifically that Fed chair career motivations matter. If you omit career considerations, then it is not so much partisan affiliation as partisan opposition that can influence monetary policy. In effect, there is a potential increase in policy rate before elections. Dentler calls this a “reverse political monetary policy cycle.”11 In essence, a Fed chair is more likely to lean into his partisan affiliation as an incumbent president seeks reelection. It is hard to prove this behavior is partisan because it conforms with the idea of a staunchly independent central bank. Now let us look at the data first hand. In the following analysis we focus on the nominal Fed funds rate alongside (1) the headline consumer price index and (2) an implied policy rate following a simple Taylor Rule using potential GDP, the core PCE deflator, and the unemployment rate.12 We chose the nominal Fed funds rate and headline consumer price index because they should provide an indication of how the US president and public perceived interest rates and inflation. These factors are critical for the president’s decisions as to whether to reappoint or replace sitting Fed chairmen. However, we also use the Taylor Rule as a proxy for the correct or appropriate policy rate at the time, recognizing that headline CPI is insufficient. We observe the following: Burns worked closely with President Nixon and his tenure has always been controversial. The simple evidence shown here suggests that he accommodated Nixon in 1972 but did not accommodate President Ford’s bid for the presidency in 1976. He might have stayed easy a bit longer than necessary in 1977 ahead of President Carter’s decision on whether to reappoint him (Chart  4).  Chart 4AArthur Burns As Fed Chair Chart 4BArthur Burns As Fed Chair Miller’s tenure was marred by stagflation. He did not accommodate the Democrats during the 1978 midterm election and probably could not have done so. Carter promoted him to Treasury Secretary as a way of removing him from the Fed chair. The episode is a reminder that the president can remove the Fed chair – as the best constitutional studies show – but he may need to get creative about how to do it to avoid a political storm (Chart 5). Volcker may have accommodated Carter somewhat but not entirely in 1980. His actions are debatable around Reagan’s election in 1984. But Volcker laid inflation low and his reappointment by Reagan in 1983 makes sense in the context of that triumph (Chart 6).  Chart 5William Miller As Fed Chair Chart 6Paul Volcker As Fed Chair Greenspan cannot really be said to have accommodated Bush in 1992 though rates fell. He cracked down on inflation regardless of the 1994 midterm election, which turned out badly for President Clinton and the Democrats. But Clinton did not hold it against him – inflation had been brought down without a recession. Greenspan was tame during Clinton’s reelection bid in 1996 despite rising inflation – he hiked rates immediately thereafter. Clinton reappointed him in the midst of a rate-hike cycle justified by rising inflation, regardless of any risk to the Democratic bid in the 2000 election (Chart 7).   Chart 7AAlan Greenspan As Fed Chair Chart 7BAlan Greenspan As Fed Chair Bernanke’s tenure was dominated by the subprime mortgage crisis and Great Recession. He cannot be said to have accommodated the Republicans in 2008, though they were doomed anyway. President Obama’s decision to reappoint him in 2009 was a clear example of an urgent need to maintain policy continuity. Obama announced his replacement in 2013, after the crisis had passed (Chart 8). Chart 8ABen Bernanke As Fed Chair Chart 8BBen Bernanke As Fed Chair Yellen’s decision to pause hiking interest rates in 2016 is debatable and can be said to have accommodated the Democratic Party that year. She was replaced by President Trump in the midst of a rate-hike cycle justified by conditions (Chart 9). Powell hiked rates four times in 2018 despite the onset of a trade war with China. Powell cannot be said to have accommodated the Republicans in the 2018 midterm election. His behavior in 2020 was dominated by the COVID-19 crisis (Chart 10). Chart 9Janet Yellen As Fed Chair Chart 10Jerome Powell As Fed Chair The point is not to claim that politics is the driving factor behind monetary policy but rather to observe the cruxes in which personal and political motivations are at least mixed with technocratic and institutional decisions. Incidentally our observations largely corroborate the relevant academic literature.  If there is one solid rule that emerges from this analysis, it is that Fed chairmen and chairwomen do not accommodate midterm elections. There are no exceptions in the data shown here. If anything they are more hawkish. At the same time, it is true (though sometimes exaggerated) that rate hikes tend to be put on pause during presidential election years. And this tendency is observable not only during times in which a crisis makes rate hikes impossible. Furthermore a close examination of these charts supports the contention that Fed chairs tend to avoid or delay rate hikes prior to the president’s decision whether to reappoint them. There are exceptions but the charts do not disconfirm the hypothesis, which is intuitive because it fits with the central banker’s self-interest.  Biden Faces Zero Risk From A New Chair Or Some Risk From Powell A flat application of the rules of thumb in the previous section would suggest that Powell will push for easier policy than necessary ahead of Biden’s decision whether to reappoint him. It would also suggest that, if reappointed, Powell will not make any special accommodation for the Democrats in the critical 2022 midterms or in 2023. Obviously the reality might work out differently this time. But it is legitimate to suggest that retaining Powell poses a risk to the Democrats’ control of the economy ahead of the 2024 elections, even though we know we will get hate mail for saying it. Investors should not assume that there is a powerful norm in favor of the president’s retaining the sitting Fed chair in the name of continuity and “doing no harm.” The modern period of the Federal Reserve begins with the Fed-Treasury Accord in 1951. There have been seven changes of the Fed chair since that time and three of them occurred because of a change of political party in the White House (Martin to Burns, Burns to Miller/Volcker, and Yellen to Powell). While President Obama retained Bernanke, the reappointment came in early 2009, in the midst of a historic crisis. Biden has much greater flexibility than that today. And while Clinton retained Greenspan, the above analysis suggests that Democrats may warn Biden against doing the same. Most importantly Biden is president at a period of peak polarization in the US, when most of his Democratic Party and the US political establishment believe that democracy itself is at risk of dying at the hands of the Trumpist populism that is overtaking the Republican Party. If this is the view then even marginal risks to Democratic election prospects over the next four years should not be willingly taken. Biden’s dilemma can be illustrated easily by game theory. If he retains Powell he runs some risk of a hawkish surprise, however small, whereas if he replaces Powell he can avoid that risk. Powell regains some individual discretion if he is reappointed and therefore a hawkish surprise cannot be ruled out. The game theory implies that Biden will opt to remove Powell, but obviously that is up to Biden. Note that there is no stable equilibrium as Powell’s decision is shown as data-dependent and indifferent to the outcome (which may not truly be the case) (Diagram 1).   Diagram 1Game Theory: Will The President Reappoint The Fed Chair? Biden must also choose a replacement for Vice Chair Richard Clarida, whose term expires in January 2022. Later, in June 2023, John Williams’s tenure on the board will expire (Diagram 2). With three new appointments Biden would be able to remake the board both slightly more dovish and considerably more diverse. Diversity and inclusiveness in top government positions are key aspects of Biden’s and the Democrats’ overall agenda.  Diagram 2Biden Could Replace At Least Three Fed Governors The history of the Fed shows that leaders tend to be captured by the institution. Powell is fully absorbed into the new Fed consensus and his personal legacy depends on executing the new ultra-dovish monetary policy strategy that he himself ushered into being. While Modern Monetary Theory (MMT) has made great strides, it is not easy for Biden to get a true believer confirmed in the Senate. In this sense, it does not matter whether Biden replaces Powell – the result will be largely the same and in line with the Fed’s current policy framework. We have a lot of sympathy with this argument. It emphasizes the checks and balances on the individual policymaker, which is the method we use to analyze US politics. The Fed has given very explicit criteria for lifting rates off the zero lower bound that are tied to specific economic outcomes. They have removed a lot of the discretion from that decision. Anyone qualified to take up the Fed chair would understand that it would be very risky to deviate from that specific guidance: the Fed would lose a lot of credibility. It would have to be a very non-mainstream pick to do that. That is not likely to happen. But again – personalities can matter at inflection points. Some would argue that Biden will not be able to find any credible candidates who can pass Senate confirmation and still be significantly more dovish than Powell (the Senate being divided equally between the two parties). However, Lael Brainard, Raphael Bostic, and Neel Kashkari are all Fed insiders who would be likely to pass the Senate and marginally more dovish than Powell, albeit supporters of the current policy framework. They would also advance the diversity agenda in different ways. They are more likely nominees than other potential candidates (Table 1).   Table 1Potential Successors To Powell As Fed Chair Note that the focus on inclusiveness is not only about personnel but also about the inclusiveness of the economy and hence it could affect monetary policy decisions. Inclusiveness as well as climate change and inequality are concerns outside of the Fed’s official mandate, where monetary policy will have a limited effect, but any influence of these issues whatsoever would point to dovish surprises. Biden can advance this agenda without legislative change through appointments.   Investment Takeaways The Fed chair appointment is a misleading win-win situation for markets. If Biden retains Powell, it is because Powell has proved thoroughly committed to the Fed’s new ultra-dovish monetary policy strategy, whereas if Biden replaces him, the replacement will be ultra-dovish. However, this win-win is misleading because beyond the near term the Fed will have to normalize policy. The Fed will ultimately remain data-dependent and the rapid closing of the output gap combined with a historic increase in excess money supply will push up inflation and require Fed responses regardless of the future chairman or chairwoman (Chart 11). Our US Bond Strategist Ryan Swift emphasizes that the Fed’s policy framework is very explicit. In order to normalize policy it needs to see inflation above the 2% target, the economy at maximum employment, and a convincing inflation overshoot (Table 2). The first goal is already met, with 12-month PCE inflation above target. An inflation overshoot will necessarily follow from the first goal combined with the second goal. Therefore the focal point for investors should be the second goal, “maximum employment,” i.e. the unemployment rate and labor participation rate (Chart 12). Positive data surprises on the employment front will accelerate the time frame. Chart 11Output Gap To Close Rapidly Table 2Checklist For Fed Liftoff Chart 12Charting The Checklist For Fed Liftoff For now we remain long TIPS relative to duration-matched nominal Treasuries in expectation of dovish policy surprises. We may modify this trade in the near future. The upside is limited now that ten-year breakevens and five-year/five-year forward breakevens have reached the point where they are consistent with the Fed’s goal of well-anchored inflation expectations. But the above analysis supports this trade. Of course, the Fed’s actions should be taken into context with fiscal policy as well as external events and the US dollar. In the near term we continue to advise a cautious approach given that the US dollar is resting at a critical juncture, around 90 on the DXY. If the dollar breaks down beneath this level then it could fall substantially further. From a macro perspective this is what we would expect given the standing of budget deficit and real interest rates. Today’s historic combination of loose fiscal, loose monetary policy is dollar-bearish (Chart 13). The implication is positive for equities, especially cyclical and value sectors, so we maintain our current positioning.  Chart 13Loose Monetary, Loose Fiscal Policy Threaten The Dollar Our sister Geopolitical Strategy highlights China among other foreign policy challenges to the bearish dollar view and global risk appetite. This summer should provide some clarity on whether global policy uncertainty will rise and reinforce the dollar’s floor (Chart 14).     Chart 14Geopolitical Risk And Policy Uncertainty Put Floor Under Dollar? Biden is still highly likely to pass an infrastructure bill this year (80% subjective odds). Any failure of bipartisan talks with Republicans will simply result in an all-Democratic bill via budget reconciliation. West Virginia Senator Joe Manchin will not prevent the passage of a bipartisan infrastructure bill and/or Biden’s next reconciliation bill (the American Jobs Plan). Manchin’s current tensions with the Democratic caucus center on the so-called “For The People” voting rights bill and the Senate filibuster, not the question of infrastructure and corporate tax hikes. Indeed Manchin may be forced to accept a higher corporate tax rate than his preferred 25% if he wants to make peace with his party. It is not inconceivable that he could defect from his party – the Republicans lost a 50-seat majority in the Senate this way as recently as 2001. But we have long argued that Manchin will support Biden’s signature legislative achievement. The market may be temporarily disappointed by stimulus hiccups but we view the infrastructure bill as a “buy the rumor, sell the news” dynamic for US cyclicals. While a fiscal policy weak spot will develop late in 2021 and early 2022, after the American Rescue Plan Act’s provisions expire but before new funds arrive from the American Jobs Plan, nevertheless the recovery of the private economy both at home and abroad should provide a bridge. The implication of the above analysis is to stay invested in the stock market and maintain a constructive outlook over the cyclical (12-month) time horizon while exercising near-term caution due to the dollar and geopolitical risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets   Footnotes 1     For political monetary cycles see Edward N. Gamber and David R. Hakes, “The Federal Reserve’s response to aggregate demand and aggregate supply shocks: Evidence of a partisan political cycle,” Southern Economic Journal 63:3 (1997), 680-91. For developed versus developing market political monetary cycles, see S. Alpanda and A. Honig, “The impact of central bank independence on political monetary cycles in advanced and developing nations,” Journal of Money, Credit and Banking 41:7 (2009), 1365-1389. 2     In the US, the Fed’s independence rests on dubious constitutional and legal supports but is nevertheless well-established in legal and political practice. See Peter Conti-Brown, “The Institutions of Federal Reserve Independence,” Yale Journal on Regulation 32 (2015), 257-310. 3    Lawrence Bauer and Alex Faseruk, “Understanding Political Pressures, Monetary Policy, and the Independence of the Federal Reserve in the United States from 1960-2019,” Journal of Management Policy and Practice 21:3 (2020), 41-63. 4    Kuttner and Posen (2007) demonstrate that financial markets respond to newsworthy developments with central bankers across the developed world. See footnote 7 below. 5    See Conti-Brown, footnote 2 above. See also Kelly H. Chang, Appointing Central Bankers: The Politics of Monetary Policy in the United States and European Union (Cambridge: CUP, 2003). 6    See Alexander W. Salter and Daniel J. Smith, “Political economists or political economists? The role of political environments in the formation of Fed policy under Burns, Greenspan, and Bernanke,” The Quarterly Review of Economics and Finance 71 (2019), 1-13. 7     See Dentler, 241. See also Ellen E. Mead, “The FOMC: Preferences, Voting, and Consensus,” Federal Reserve Bank of St. Louis Reivew 87:2 (2005), 93-101; Kenneth N. Kuttner and Adam S. Posen, “Do Markets Care Who Chairs the Central Bank?” National Bureau of Economic Research, Working Paper 13101 (May 2007), nber.org.  8    B. A. Abrams and P. Iossifov, “Does the Fed contribute to a political business cycle?” Public Choice 129 (2006), 249-62. 9    Gamber and Hakes, “The Taylor rule and the appointment cycle of the chairperson of the Federal Reserve,” Journal of Economics and Business 58 (2006), 55-66. 10   Alexander Dentler, “Did the Fed raise interest rates before elections?” Public Choice 181 (2019), 239-73. 11    Dentler, 259, characterizes the Fed chairs as follows: “We believe that Martin was more susceptible to political infuences than his colleagues, but he never worked in opposition to a president in our sample period. Neither did Arthur Burns; however, we find him to be a moderating force with respect to ideological biases, though he appears to have been vulnerable to threats regarding his career. We find Volcker to respond more strongly than most other chairs to ideological motives and career incentives. Greenspan, on the other hand, did not fall prey to biased behavior that characterizes the other chairs. Bernanke’s tenure is probably the most difficult to interpret.” 12    Real Potential GDP Growth + Core PCE Deflator + 0.5 * (Core PCE Deflator – 2% Target) - 0.5 * (Unemployment Rate – NAIRU). We prefer real potential GDP to estimates of the real neutral rate because it is simpler and more transparent.  

Highlights Bond Market Performance: Government bonds in the developed economies are currently trapped in ranges, consolidating the sharp upward moves seen in the first quarter of 2021. This is only a pause in the broader cyclical uptrend, however, with central banks under increasing pressure to turn less dovish amid surging inflation and tightening labor markets. Oversold USTs: Technical indicators of yield/price momentum and investor sentiment/positioning suggest that US Treasuries are oversold. Working off this condition can take another 2-3 months, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation for Australian government bonds to overweight on a tactical (0-6 months) investment horizon. Feature Dear Client, Next week, in lieu of our regularly weekly report, I will be hosting a webcast on Tuesday, June 15 where I will discuss the outlook for global fixed income markets in the second half of 2021. Following that, we will be jointly publishing our bi-annual Global Central Bank Monitor Chartbook with our colleagues at BCA Research Foreign Exchange Strategy on Friday, June 18th. We will return to our regular publishing schedule on Tuesday, June 29th. Best Regards, Rob Robis Chart of the WeekA Tale Of Two Quarters The performance of government bond markets in the developed world so far in 2021 has been a tale of two quarters. In Q1, yields were rising steadily on the back of upside surprises in global growth and emerging signs of the biggest inflation upturn seen in nearly a generation. The Bloomberg Barclays Global Treasury index delivered a total return of -2.7% (hedged into US dollars) during the quarter, with no country escaping losses (Chart of the Week). The biggest declines were seen in the UK (-7.5%) the US (-4.3%), with the smallest losses occurring in Japan (-0.3%) and Italy (-0.7%). Chart 2Lower Vol Means High Yielders Outperform Low Yielders Q2 has been a different story, however. Yields have retreated somewhat from the year-to-date peaks seen at the end of Q1, leading to positive returns so far in Q2 in the UK (+0.8), the US (+1.2%) and Australia (+1.1%). The laggards are the low yielding euro area markets, most notably Italy (-0.7%) and France (-0.9%), that have seen yields move higher on the back of accelerating European growth. The Q2 returns look very much like a carry-driven market, with higher-yielding markets outperforming lower-yielding ones. That trend can persist if the current backdrop of low market volatility persists (Chart 2), although this calm will eventually be broken by a shift towards less dovish monetary policies. Some countries will make that shift at a faster pace than others, leading to relative value opportunities for bond investors in the latter half of 2021. This week, we discuss one such opportunity – Australia versus the US. US Treasuries: Oversold & Trendless – For Now After reaching a 2021 intraday high of 1.77% back on March 30, the benchmark 10-year US Treasury yield has traded in a narrow 15bp range between 1.55% and 1.70%. From a fundamental perspective, US yields are lacking direction because inflation expectations have already made a major upward adjustment to the more inflationary backdrop, but real yields have remained depressed by the continued dovish messaging from the Fed – for now - with regards to the timing of tapering or future rate hikes. From a technical perspective, however, the sideways pattern for US Treasury yields is also consistent for a market that trying to work off an oversold condition. Most of the technical indicators for the US Treasury market that we monitor regularly were at or close to the most bearish/oversold extremes seen since 2000 (Chart 3): Chart 3US Treasuries Are Working Off An Oversold Condition The 10-year Treasury yield is 39bps above its 200-day moving average, but that gap was as high as 84bps on March 19; The 26-week total return of the 10-year Treasury is -4.7%, after reaching a low of -8.8% on March 19; The JP Morgan client survey of bond managers and traders shows some of the largest underweight duration positioning in the 19-year history of the series; The Market Vane index of sentiment for Treasuries is in the bottom half of the range that has prevailed since 2000; The CFTC data on positioning in 10-year Treasury futures is the only one of our indicators that is not signaling an oversold market, with a small net long position of +3% (scaled by open interest). The overall message of these indicators suggests that price momentum and positioning reached such a bearish extreme by mid-March that some pullback in Treasury yields was inevitable. However, a look back at past periods when Treasuries became heavily oversold since the turn of the century shows that the duration and magnitude of such a pullback is highly variable – anywhere from two months to ten months. The main determining factors are the trends in economic growth and inflation in the US, and the Fed’s expected policy response to both. To show this, we conducted a simple study, updating work we first presented in a 2018 report.1 We looked at “oversold episodes” since 2000, which began when the 10-year Treasury yield was trading at least 50bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield subsequently converged back to its 200-day moving average. We then looked at the length of the episode (in days), and the change in bond yields, for each oversold episode. There were nine such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we rank the episodes by the number of days it took to complete each one, based on our simple moving average rule. We also show the change in both the 10-year Treasury yield and its 200-day moving average during each episode, to show how the convergence between the two unfolds. Table 1A Look At Prior Episodes Of An Oversold Treasury Market To describe the US economic backdrop during each episode, we looked at the change in the ISM manufacturing index and core PCE inflation during those oversold periods. We also show changes in two important determinants of the level of Treasury yields: inflation expectations using 10-year TIPS breakeven rates, and Fed rate hike expectations using our 12-month Fed discounter which measures the expected change in interest rates - one year ahead - priced into the US overnight index swap (OIS) curve. At the bottom of the table, we show the average for all nine oversold episodes, as well as the averages for the episodes were the ISM was rising and where core PCE inflation was rising. Chart 4US Treasury Market Oversold Episodes: 2003-2007 There are a few messages gleaned from the results in Table 1: The longest correction of an oversold Treasury market since 2000 took place between February 2018 and December 2018, when 305 days passed before the 10-year yield fell back to its 200-day moving average; The shortest correction was between June 2007 and August 2007, where only 52 days elapsed; Treasury yields typically decline during oversold periods, with two notable exceptions: 2018 and 2013/14, which were also the two longest episodes; During all of the oversold periods, markets reduced the amount of expected Fed tightening by an average of 26bps. However, that was entirely concentrated in four of the nine episodes - including three of the four shortest episodes – and is typically associated with a decline in inflation expectations. Growth momentum appears to be a bigger factor than inflation momentum in determining the length of an oversold episode, with longer episodes typically occurring alongside a rising ISM index, and vice versa. The notable exception was the longest episode in 2018, where the ISM declined by six points, although the bulk of that decline occurred in a single month at the end of the period (November 2018). For the more visually oriented, we present the time series for all the data in Table 1, shaded for the oversold periods, in Chart 4 (for the 2003-2007 period), Chart 5 (2008-2012), Chart 6 (2013-2017) and Chart 7 (2018 to today). We’ve added one additional variable – our Fed Monitor, designed to signal the need for tighter or looser US monetary policy – in the bottom panel of each of those charts. Chart 5US Treasury Market Oversold Episodes: 2008-2012 Chart 6US Treasury Market Oversold Episodes: 2013-2017 Chart 7US Treasury Market Oversold Episodes: 2018 To Today What does this look back tell us about looking ahead? The current episode, at only 105 days old, is still 62 days “younger” than the average oversold period, and 76 days “younger” than the average period where core inflation was rising. This would put the end of the current episode sometime in August. The ISM is essentially unchanged over the current episode so far, making it difficult to draw conclusions based on growth momentum – although the longest episode in 2018 shows that yields can trade sideways for a long time, even in the absence of a big slowing of growth, if the Fed is in a rate hiking cycle. However, the current episode differs dramatically from others in this analysis on two critical fronts. Core inflation has surged 1.6 percentage points since the oversold period began in February, far more than any other episode, while the gap between a rapidly increasing Fed Monitor and a flat 12-month Fed Discounter is also unique among post-2000 oversold periods. In other words, the Treasury market is still vulnerable to a repricing of Fed tightening expectations, especially with positioning and sentiment measures like the Market Vane survey and net futures positioning not yet at fully bearish extremes. Bottom Line: The current oversold condition in the US Treasury market can take another 2-3 months to unwind, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist Update: No Case For A Hawkish Turn Yet Australia has been one of the top performing government bond markets within the developed economies, as discussed earlier. This performance has occurred even with strong acceleration of both Australian economic momentum and market-based inflation expectations (Chart 8). Despite our RBA Monitor flashing pressure on the RBA to tighten, and the Australian OIS curve already discounting 48bps of rate hikes over the next two years, Australian bond yields have remained very well behaved during the “calm” second quarter for global fixed income. Chart 8RBA Policies Limiting Rise In Bond Yields Chart 9RBA Stimulus Takes Many Forms The continued dovish messaging from the Reserve Bank of Australia (RBA) is the main reason for the solid Australia bond performance. The central bank is signaling no imminent shift in its combination of 0.1% nominal policy rates, deeply negative real rates, yield curve control on 3-year bonds and quantitative easing on longer-maturity bonds (Chart 9). Other central banks are starting to inch towards reining in the massive monetary accommodation of the past year. Could the RBA be next? In a Special Report published back in January of this year, we outlined a list of variables to watch to determine when the Reserve Bank of Australia (RBA) could be expected to turn less dovish.2 This checklist would also inform our country allocation view on Australian government bonds, which has remained neutral. A quick update on the latest readings from the RBA Checklist shows little pressure on the RBA to begin preparing markets for tighter monetary policy. 1. The vaccination process goes quickly and smoothly We are NOT placing a checkmark next to this part of our RBA Checklist. Australia has weathered COVID-19 far better than most other Western countries in terms of actual cases and deaths, but the vaccine rollout Down Under has been underwhelming. Only 16% of the population has received at least one vaccine jab, while a mere 2% is fully vaccinated. These are numbers that are more comparable to pandemic-ravaged emerging market countries like India and Brazil where access to vaccines is an issue (Chart 10). Chart 10A Slow Vaccine Rollout Down Under The slow vaccine rollout is less worrisome in light of the Australian government having secured enough vaccine doses to inoculate the entire population, and with the domestic economy facing limited remaining COVID-19 restrictions. The issue has been distribution and that is now occurring at a quickening pace. Until a much greater share of the population is vaccinated, however, Australia will continue to maintain aggressive COVID-related international travel restrictions – the government just announced that borders will remain shut until mid-2022 - that will be a major drag on the economically-important tourism sector. 2. Private sector demand accelerates alongside fiscal stimulus (✔) We ARE placing a checkmark next to this part of our RBA Checklist. Australia’s fiscal stimulus in response to the pandemic was one of the largest in the developed world. The stimulus was heavily focused on wage subsidies and income support measures like the JobSeeker program, which expired back in March. As the expensive stimulus programs are unwound, it is critical that the domestic economy can stand on its own without support. On that front, the news is good. Australia’s economy grew by 1.8% during Q1/2021, lifting the level of real GDP above the pre-pandemic peak (Chart 11). Both consumer spending and business investment posted solid growth during the quarter, fueled by surging confidence with the NAB business outlook measure hitting a record high in May (bottom panel). As a sign that the domestic economy is benefitting from a return to pre-pandemic habits, Q1 saw a 15% increase in spending in hotels, cafes and restaurants. That strength looked to extend into the Q2, with retail sales rising 1.1% in April, suggesting that Australian domestic demand is enjoying strong upward momentum. Chart 11A Confidence-Led Recovery In Domestic Demand Chart 12China Is A Drag On Australian Exports 3. China reins in policy stimulus by less than expected We are NOT placing a checkmark next to this part of our RBA Checklist. China is by far Australia’s largest trading partner, so Chinese demand is always an important contributor to Australian economic growth. This is why we included a China element in our RBA Checklist. Specifically, we deemed the outcome that would potentially turn the RBA more hawkish would be Chinese policymakers pulling back monetary and fiscal stimulus by less than expected in 2021 after the big policy support in 2020. The combined fiscal and credit impulse for China has already slowed by 9% of GDP since December 2020, signaling a meaningful cooling of Chinese growth in the latter half of 2021 that should weigh on demand for imports from Australia (Chart 12). However, Chinese import demand has already been severely impacted because of worsening China-Australia political tensions, which has led Beijing to impose restrictions on Australian imports for a variety of products, include coal, wine, beef, barley and cotton. The result is that there has been no growth in Australian total exports to China over the past year – an outcome that was flattered by the surge in iron ore prices - which has weighed on overall Australian export growth. Given this weak starting point for Chinese demand for Australian goods, the sharp reduction in the China stimulus is, on the margin, a factor that will not force the RBA to turn less dovish sooner than expected. 4. Inflation, both realized and expected, returns to the RBA’s 2-3% target We are NOT placing a checkmark next to this part of our RBA Checklist. Australian inflation remains well below the RBA’s 2-3% target range, with the headline CPI and the less volatile trimmed mean CPI both expanding at only a 1.1% annual rate in Q1/2021 (Chart 13). The RBA is forecasting a brief boost to both measures in Q2, before settling back below 2% to the end of 2022. Chart 13No Bond-Bearish RBA Policy Shift Without More Inflation Chart 14Diminishing Financial Stability Risks From Housing The RBA’s message on the inflation outlook has been very consistent. A sustainable move of realized inflation back to the 2-3% target range – that would prompt a normalization of monetary policy – cannot occur without a significant tightening of labor markets that drives wage growth back to 3% from the Q1/2021 reading of 1.5%. The RBA currently does not expect that outcome to occur before 2024. The RBA believes that the full employment NAIRU is between 4-4.5%, well below the OECD’s latest estimate of 5.4%. Given the sharp drop in Australian unemployment already seen over the past few quarters, there is the potential for an upside surprise in the wage data that could lead the RBA to change its policy bias. The central bank would need to see a few quarters of such wage surprises, however, before altering its forward guidance on the timing of future rate hikes. 5. House price inflation begins to accelerate We are NOT placing a checkmark next to this part of our RBA Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets were overheating could prompt the RBA to consider tighten monetary policy. The annual growth of median house prices has dipped from +8% in Q1 2020 to +4% in Q4 2020, despite robust housing demand as evidenced by the 40% growth in building approvals. At the same time, housing valuations have become less stretched with the ratio of median home prices to median household incomes falling -9% from the 2017 peak according to data from the OECD (Chart 14). The RBA remains sensitive to the potential financial stability risks from overvalued housing. The latest trends in the house price data, however, suggest that the central bank does not yet to have the use the blunt tool of tighter monetary policy to cool off an overheated housing market. Chart 15Upgrade Australia To Overweight (Vs. USTs) In sum, the majority of items in our RBA Checklist are signaling no immediate pressure on the central bank to tighten policy. The first 25bp rate hike is not discounted in the Australian OIS curve until April 2023, a little ahead of RBA guidance but still consistent with a very dovish policy bias. The inflation data, in our view, will be the critical factor that could prompt the markets to pull forward expected monetary tightening, leading to a surge in Australian bond yields. With the RBA already expecting a surge in inflation in the Q2/2020 data, the central bank would likely want to see at least a couple of more quarterly inflation prints – both for the CPI and wage price index - before signaling a more hawkish policy shift. Thus, the RBA will likely stay dovish over the latter half of 2021 Therefore, we are moving to an overweight recommended stance on Australian government bonds on a tactical (0-6 months) basis. In our model bond portfolio on pages 16-17, we are “funding” that shift to an above-benchmark weighting in Australia out of US Treasury exposure. Given our view that the Fed will soon begin to signal a 2022 taper of its asset purchases, relative policy dovishness should lead Australian government bonds to outperform US Treasuries in the latter half of this year. In addition, Australian bonds have a lower yield beta to changes in US Treasury yields, relative to the high beta to changes in non-US developed market yields (Chart 15), making allocations out of the US into Australia attractive from a risk management perspective in a global bond portfolio. Bottom Line: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation to Australian government bonds to overweight on a tactical investment horizon.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 See BCA Research Global Fixed Income Strategy Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20, 2018. 2 See BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, I am delighted to take charge of the US Equity Strategy publication upon Anastasios Avgeriou’s departure. By way of introduction, I have been an investor for nearly 20 years, with my career spanning both the buy and sell side, bottom-up stock selection and top-down asset allocation, and fundamental and quantitative approaches to investing. I have invested through two business cycles (starting on the third one now), watched the internet stock bubble burst, and seen grown men shedding tears on Bloomberg keyboards in the summer of 2008 – the market has a way of humbling us, mere mortals. As a result of these diverse professional experiences, I became an agnostic and don’t believe there is one correct way to invest as long as a thesis is well thought through and backed up by numbers and in-depth analysis. I believe that different approaches to investing, fundamental and quant, bottom up and top down, should complement each other leading to “best of all worlds” results.  I also rely on an investment framework which is disciplined enough to offer a structure to fall back on to minimize behavioral biases, and yet is flexible to rapidly accommodate both “black swan” and “grey rhino” themes into investment decision-making. The following are the guiding principles of this investment framework. I hope this week’s publication will provide insights into my approach to investing and the nature of the US Equity Strategy product under my stewardship. I look forward to your feedback and suggestions. Kind Regards, Irene Tunkel Chief Strategist, US Equity Strategy   Principle 1: The Business Cycle Matters The business cycle and macroeconomic conditions are the cornerstones of any investment decision as they underpin the fundamentals of most assets, and preordain the types of assets likely to outperform based on their level of risk and sensitivity to economic growth. Analyzing the stages of the business cycle is a succinct way to summarize a wide range of economic data, such as capacity utilization, growth, policy, credit conditions and valuation. Each business cycle is different, yet on average across all cycles, the stages have the following characteristics (Table 1). Table 1Business Cycle Is In Expansion Stage Recovery: Policy is easy, and liquidity is plentiful, profits rebound but growth is scarce, inflation is low, risk aversion elevated, and stocks are still cheap. In this environment cyclicals, small caps and value outperform. Expansion: Policy is neutral, inflation is moderate, growth is abundant, risk aversion is low. During this phase it is cyclicals and small caps that shine. Slowdown: Inflation is higher, and policy is tightened, growth is rolling over, valuations are extended, and risk aversion is rising. In this environment of slowing growth, growth stocks, large caps, defensives and real assets outperform (Chart 1). Contraction: Deflation (or fears thereof) ensues, output is falling, growth is scarce and risk aversion is high. In this environment defensives, quality and highly profitable stocks rule the day. Chart 1Performance Of Equities In Different Stages Of Business Cycle Although the pandemic is barely over, the markets have galloped through the recovery stage and have landed squarely in expansion territory. US equities exhibited exceptional earnings growth of 52.5% year-on-year in Q1-2021 on the back of economic reopening, fiscal and monetary stimulus, and pent-up demand. Monetary and fiscal policy remain easy. The only deviation from a textbook description of expansion is low capacity utilization and a high unemployment rate which persist as aftereffects of factors specific to the pandemic: School closures and elevated unemployment benefits. High unemployment whilst demand for labor is high triggered inflationary pressures. However, we believe that we are near the end of the expansion stage and are about to transition into a moderate slowdown. While growth is to remain robust, it is bound to slow modestly from its peak: The Manufacturing ISM PMI came down from 64.7 in April to 61.2 in June. According to Bloomberg consensus estimates GDP growth is to slow from 6.4% in 2021 to 4% in 2022. The Fed is starting to “talk about talking about tightening”, and with inflation elevated many expect somewhat hawkish rhetoric/intervention from the Fed sooner than the end of 2022. Valuations are rich. Now may be opportune time to reposition for a slowdown to be ahead of the game. To do well in a slowdown stage, which may last for months but by no means heralds the end of a bull market in equities, we recommend dusting off growth, large-cap and defensive stocks and taking profits in some of the recent cyclical outperformers. A barbell approach may do well at this point, with portfolio overweights in both cyclical sectors such as energy and industrials along with more defensive plays such as health care and technology Principle 2: Shocks And Transient Themes Trump Both Macro And Fundamentals Macro is important on the cyclical time horizon but, intra-cycle, it is transient themes and macro shocks that move markets. These themes, also known as “black swans” and “grey rhinos”, are exogenous shocks and developments that dominate investor psyche. Mostly, they are policy driven, like trade war or fiscal stimulus, but occasionally are force majeure events, like Covid-19. Transient themes may have a positive or negative effect on the market. These are news and developments that are not immediately priced by the market but are not to be ignored or dismissed: They dominate investment outcomes irrespective of the normal market order of things. Usually transient themes are short-lived and fade once macroeconomic and fundamental data have readjusted to the new reality: Economic and earnings growth estimates have been revised, and relevant stock and sector returns have absorbed the shock. Back in March 2020, neither fundamentals nor valuations mattered. Nor did macro. Stocks were first sledgehammered by a “corona” theme, and then soared on a “liquidity is abundant” theme. It took analysts three months to downgrade US GDP growth to contraction (Chart 2)! Over the past few months, the only theme that seemed to matter to market participants was inflation, and inflation alone. Implications? Fear of inflation and sooner-than-expected Fed tightening have triggered an energetic selloff in bonds and defensive/growth equities. However, there are early signs that this theme is beginning to fade with rates stabilizing and growth stocks rebounding (Chart 3). Chart 2Markets Take Time To Price In Shocks Chart 3Inflation Fears Triggered Equity Rotation Principle 3: Interplay Between Valuations And Fundamentals Once the macro backdrop and transient themes are well understood, we zoom in our analysis to the valuations and fundamentals of individual styles and sectors to select the most attractive opportunities. Ideally, we are looking for the reasonably priced sectors that have solid fundamentals and can deliver strong growth. Finding sectors like that is easier said than done: Rarely do good and cheap exist in the same incarnation. Hence, investors need to compromise: Buy cheap stocks with poor earnings growth and challenged fundamentals or pay a premium for solid growth. A classic value/growth dilemma. Our approach is as follows: Cheap Sectors: Relative valuations are very important: Most value investments are mean-reversion plays (Chart 4) We don’t attach much weight to fundamentals – we don’t expect a stellar balance sheet or earnings growth In order to screen out value traps, we are looking for a catalyst for mean reversion For cheap stocks valuations are more important than fundamentals. Expensive Sectors: Relative valuations are much less important than growth expectations and fundamentals. Are fundamentals continuing to improve or have they reached a peak? Is earnings growth about to accelerate or slow? If fundamentals, e.g. RoE or margins are improving, and a slowdown in growth is not expected, then the valuation premium is justified. Chart 4Value Is Mean Reverting The software industry group is a case in point. Back in 2019-2020 valuations were eyewatering (more than two standard deviations above 10 years of history) but earnings growth was resilient, and profitability was in a multi-year upward trend. The valuation premium was justified. But late in 2020 RoE started deteriorating, and the industry group experienced a pullback. More recently, RoE has stabilized and turned. Returns are following (Chart 5). Chart 5Changes In Profitability Drive Valuations Principle 4: Stock Markets Are Markets Of Stocks Understanding the behavior of individual stocks makes top-down sector and style selection much more informed and nuanced. After all, we are dealing not just with a stock market, but with a market of stocks. Those glued to Bloomberg screens in March 2020 may have noticed a rare green with companies like Zoom, Citrix and Amazon rallying amidst stock Armageddon. These were green shoots (no pun intended) of one the most vigorous stock market rallies in history. Paying attention to stock-level data also gave an early pointer that pandemic shutdowns, as awful as they were, would be a boon for selected technology and e-commerce sectors (Chart 6). At present, we notice that cyclicals have not outperformed defensives since March. We also notice over the past two-to-three weeks the comeback of hot technology stocks, many of which are former “Covid-19 winners”, beaten up by a “back-to-work rally”. These are fintech and e-commerce names such as PayPal, Pinterest and Peloton, some of which are more than 50% off from their February peak. Reversal in performance of growth stocks is a sign that rates have stabilized, inflation fears are overdone, and US economic growth is gradually slowing.   Chart 6Covid-19 Winners Led S&P 500 Rebound Principle 5: Markets Are Forward Looking As Warren Buffet succinctly put it “buy risky assets when there is blood in the streets”, and “be fearful [i.e., sell], when others are greedy.” In other words, it is important to anticipate turning points, and be one step ahead of the market. Last year’s rally is a case in point, with the S&P 500 delivering the best return in history despite not having much to show for it in terms of earnings growth, with nearly 70% of S&P 500 returns coming from multiple expansion. Investors looked past shutdowns, rightly believing that the profit recession is transitory, companies are in sound financial health, valuations are at abysmal, once-in-a-lifetime, levels, and the V-shaped recovery will ensue once the pandemic is over (Chart 7). Chart 7Stocks Returns Lead Earnings   Conversely, the Q1-2021 earnings season was stellar, but many stocks, even those which exceeded expectations, have ceded gains: Stocks are priced to perfection, and investors concluded that, for some of them, the best days are behind, and growth is slowing (Chart 8). At present, trailing valuations of nearly all sectors and styles in the S&P 500 are at extreme levels, trading at 36x trailing earnings. However, forward PEs are on average 9 points lower, around 21x forward earnings. Hope is that the stock market will rerate and grow into its big shoes within the next 12 months with expected EPS growth of 23%. We think it will! Chart 8During Q1-2021 Earning Season, Beats Were Not Rewarded  Principle 6: Asset Prices Respond To The “Second Derivative” This principle is a corollary to “markets are forward looking”. Usually the rate of growth is already priced in, as markets are efficient and new information arrives as a change in expected growth, i.e. the impulse. Change in the growth outlook is absorbed by the markets and is a leading indicator of turning points in equity returns. Most often the impulse relates to change in economic or earnings growth expectations. For example, sales for the hotels industry group are still falling, but at a lower rate than before (the second derivative is improving). These “less bad” numbers are enough to send hotels returns soaring (Chart 9). Chart 9Hotels Are Rallying On “Less Bad” Sales Principle 7: Thematic Investing: Channeling Cathie Woods Thematic investing is really “smart” momentum investing, but its appeal lies in being able to identify a theme/catalyst that unites stocks and makes them move in unison. Knowing a theme behind momentum helps one to understand its thematic drivers and anticipate turning points. Arguably, thematic investing is a nuisance for stock pickers, but a boon for top-down investors: Identifying a theme has a higher impact on portfolio returns than choosing the individual stocks to represent it. For example, identifying recovery in air travel and investing into the Jets ETF is a more important decision than choosing the right airline stock. Since February 2020, American Airlines is 94% and Delta is 98% correlated with Jets ETF (Chart 10). Knowing the drivers, we can brainstorm what can trigger a reversal of this theme, for example: An increase in the price of oil, a structural shift in business travel, falling consumer confidence, and a high household dissaving rate. Thematic investing is popular as it allows an investor to ride the momentum yet also be equipped to anticipate turning points. Chart 10Air Travel Stocks Are Highly Correlated Thematic investing may be over a variety of investment horizons (stocks benefitting from retirement of baby boomers being an example of a structural theme versus stocks benefitting from post-corona supply-chain disruption being (hopefully) a short-lived theme). Further, themes can be high tech, such as autonomous driving or green energy, and low tech, such as the pandemic “puppy boom”. The most prominent and widely discussed themes in the recent months are “Covid-19 winners” vs “back to work”. Arguably, thematic investing is the “passive investing” of the future – a trend illustrated by the popularity of the ARK funds managed by Cathie Woods. Going forward, the US Equity service will be covering investment themes in a series of Special Reports. Principle 8: “No Country Is An Island” Lastly, while the focus of this publication is squarely on the US equity market, it is important to keep an eye on developments in the rest of the world. Companies in the S&P 500 derive 43% of sales from abroad. As a result, corporate earnings are highly sensitive to the direction of the trade-weighted dollar both due to the price of goods and to translation effects. Recent depreciation of the dollar will boost corporate earnings growth, especially for the technology (58% of earnings outside the US), materials (56%) and energy (50%) sectors. It takes roughly three to six months to fully absorb dollar moves into sales growth (Chart 11). Further, the economic growth rates of the major US trading partners, i.e., Europe, Mexico, Canada, and China, also have a profound effect on the US economy with transmission through the US trade balance, dollar movements and Treasury yields (Chart 12). Chart 11US Dollar Drives S&P 500 Sales Chart 12Major US Trading Partners Affect US Economy Bottom Line Markets are complex: Macro works until it does not, expensive stocks can be a good investment, and an equity rally may take off in the midst of an earnings recession. Yet, we believe that the eight principles of investing that we have outlined above will guide us through the noise and help successfully navigate equity markets. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com  

Special Report

Dear Client, In this special report we are pleased to introduce Ritika Mankar, the newest Strategist to join BCA Research and Geopolitical Strategy. Ritika hails from Mumbai where she has led a distinguished career as a director at Ambit, an institutional equity brokerage, leading one of the top macro research franchises in India. She is also a director on the board of CFA Society India. Going forward Ritika will oversee Geopolitical Strategy’s India and South Asia analysis. In this report Ritika argues that owing to both under-investment and under-employment, India’s growth engine is set to misfire in FY22. Investors should pare their exposure to Indian assets for now. I trust you will find the report insightful and will look forward to Ritika’s regular contributions, which will deepen our global coverage of market-relevant geopolitical trends and themes. Sincerely, Matt Gertken Geopolitical Strategist   Highlights Indian equities have outperformed emerging market equities decisively since March 2020. But a festering jobs problem in the informal sector and weak consumer confidence, will mean that both consumption and investment growth could disappoint in FY22. We recommend closing the Long Indian / Short Chinese Equities trade and the Long Indian Local Currency Bond / Short EM Bonds trade. We launch two new trades: Short India Banks and Long India Consumer Discretionary. Feature India has been the blue-eyed boy of the emerging market space since the dawn of the twenty-first century. Narratives about India have had a marked bullish tilt. To be fair, this optimism is justified most of the time for three very good reasons. Firstly, India’s geopolitical backdrop has improved. At home, the aftermath of the Great Recession saw the emergence of a new policy consensus consisting of nationalism and economic development. Indian policymakers recognize that if they undertake reforms to boost productivity then India has a chance of achieving a stronger strategic position in South Asia than military might alone can give it. Abroad, India is being courted by foreign powers and foreign investors. The United States has broken up the special relationship it maintained with China since the early 1970s. India stands to benefit from the West’s need now to counter-balance China. Secondly, India’s growth engine relies primarily on consumption as compared to more volatile components like net exports. Consumption makes up 56% of GDP. A consumption-powered economy that is young and not yet saturated with consumer goods, from washing machines to cars, deserves a premium. Growth in such an economy is likely to be far more predictable as compared to an export-driven economy that must contend with commodity price cycles, foreign business cycles, and de-globalization. Thirdly, India scores over other emerging markets as it offers political stability in a well-entrenched democratic framework. Despite having a low per capita income, India has a political system that is comparable to that of high-income developed countries. India’s head of state has been democratically elected since 1951 and the government at the centre has completed its full five-year term every time since 1999. More importantly, India’s institutions by design are “inclusive.”1 Institutions that provide checks and balances also deliver most of the time. So, unlike say in the case of China, Russia, Brazil, or even Turkey, India rarely gives an emerging market fund manager sleepless nights on account of politics or policy unpredictability. Whilst India deserves the premium it attracts most of the time, in this note we highlight that the market seems to be underpricing certain material risks that are building up in India. Distinct from the challenges created by COVID-19 (more on this later), India’s growth engine appears to be sputtering as two key faults develop: Under-investment: India has underinvested in capital creation for over a decade now. With government finances stretched, and with middling capacity utilization rates, investment growth in the short run is likely to stay compromised. Under-employment: India’s high GDP growth rate over the last few years has not been accompanied by an expansion in employment. Even before the pandemic, the Indian economy’s growth process had been asymmetric (or K-shaped) with the majority’s employment prospects worsening while a limited minority’s economic prospects were improving. This trend has become even more entrenched post-pandemic. Till India’s fast-compounding unemployment problem is solved, consumption growth in India will disappoint. And until then, only a select few upwardly mobile consumers of the service economy and business class will be supporting consumption growth in India. Both these dynamics will hurt India’s ability to grow its economy in the short term. These faults could force policymakers to take imprudent fiscal decisions to boost growth in the medium term too. Against this backdrop and with MSCI India trading at a 79% premium to EMs versus a two-year average of 57%, we reckon that the time is right for investors to scale down their exposure to segments of the Indian market where valuations look stretched. This report is divided into three segments: Segment 1: India’s GDP in FY22: Brace for disappointments Segment 2: COVID-19 in India: The road to normalcy will be long Segment 3: Investment conclusions India GDP In FY22: Brace For Disappointments Both the under-investment and the under-employment problem predate the COVID-19 crisis. Even as a degree of reflation kicks in as the second wave of COVID-19 infections abates, both these problems will act as a drag on India’s GDP growth in FY22. Investment Growth In India To Stay Constrained In FY22 The importance of investment in India is often underrated. Not only does gross fixed capital formation make up a third of India’s GDP each year, it also plays a critical role in driving consumption growth over the subsequent period (Chart 1). Occasional upcycles in investment are required to ensure that income growth remains robust, which in turn powers consumption growth. What is worrying is that India’s investment-to-GDP ratio had been trending downwards even before the onset of COVID-19 (Chart 2). This ratio in fact has been inching lower since the global financial crisis (GFC) from a peak of 36% to 29% in FY20. Unsurprisingly, investments have fallen further following the pandemic. The investment-to-GDP ratio fell to 27% in FY21 which is the lowest reading for this metric since the bursting of the dot-com bubble in 2001. Chart 1Consumption Growth Today, Is A Function Of Investments Made In The Past Chart 2India’s Investment To Gdp Ratio Has Been Trending Lower Since The GFC In addition, India’s investment-to-GDP ratio appears likely to stay constrained in FY22 as well. This is because the government sector and the private corporate sector (which together account for 62% of India’s investments) are unlikely to have the ability or incentive to expand capacity. Government “big push” is missing: The stock of capital in any country is created by the household sector, the private corporate sector, and the government sector. In India’s case, the government accounts for about 25% of capital formation on a cross-cycle basis. India’s government has consistently underinvested in growing its capital stock. For instance, the central government’s allocation towards capital expenditure has stayed range-bound between 1.5%-2.5% of GDP for over a decade now (see Chart 2). Hence India has not had the benefit of a big push from the government to create capital assets, such as the Four Asian Tigers undertook in the 1970-80s and China undertook in the 1990s. To be fair, the Union Budget for FY22 envisages an increase in capital expenditure to 2.5% of GDP from 2.2% of GDP last year. However, this increase is small, and we worry that the actual government spending on capital investments could well surprise to the downside. Moreover government revenues could get crimped owing to the second wave of COVID-19 in India. History suggests that government capital expenditure priorities are often set aside when India confronts a crisis. Following the GFC, the Indian central government expanded its fiscal deficit from 2.6% of GDP in FY08 to 6.1% of GDP in FY09. However, a breakdown of expenditure-side data suggests that this increase was mainly driven by higher revenue spends. Capital expenditure in fact was cut back from 2.4% of GDP in FY08 to 1.6% of GDP in FY09.   Private sector faces low demand: The private sector accounts for about 37% of capital formation on a cross-cycle basis. The private corporate sector is unlikely to want to fire up investments in FY22 as the demand scenario looks weak and capacity utilization rates in the economy are middling. Whilst specific sectors and companies are growing, consumer confidence in India on an economy-wide level remains low thereby pointing to a lackluster demand environment. The post-2020 revival in consumer confidence in India, surveys suggest, has been weaker than that experienced by developed and developing country peers (Chart 3). History suggests that upturns in the investment cycle are triggered when capacity utilization rates hover at 74% or more (Chart 4). Reserve Bank of India’s latest capacity utilization survey suggests that utilization rates were recorded at only 67% in 4Q 2020. So, with consumer confidence levels low and with capacity utilization rates not being high enough, an economy-wide upsurge in investment growth in India at this stage appears unlikely. Chart 3Consumer Confidence In India Is Yet To Return To Pre-2020 Levels Chart 4Capacity Utilization Rates In India Are Low And Hovering At Less Than 70% Levels ​​​​​​​Finally, the household sector accounts for about 38% of capital formation and is the only source of hope. Whilst the upper-income segment of India’s household sector may have the financial firepower to support investment growth, the lower income segment is unlikely to be able to drive investments in an environment of poor jobs growth. Large-Scale Unemployment Likely In India’s Unreported Underbelly Unlike most developing and developed countries, data on India’s monthly employment situation is not collected. But piecing together jobs data from a range of sources makes it clear that India’s job market is undergoing a meaningful squeeze. These job losses in India’s mid- and low-income groups will restrain consumption growth in India in FY22. GDP growth not translating into employment growth: The last pan-India employment survey was conducted in 2019. An analysis of these historical surveys suggests that India’s high GDP growth rate has not been translating into high employment growth in India for a while. The formal employment data could be understating the extent of unemployment in India and even the official unemployment rate has not fallen despite high GDP growth (Chart 5). Chart 5Even When Gdp Growth Is High, Unemployment Rates In India Remain Elevated Chart 6For Most Of India’s Population, Business Relevance Of Education And Digital Preparedness Is Poor Unless India’s manufacturing sector grows rapidly, the widening rift between India’s GDP growth rate and jobs growth rate could become a structural phenomenon. Whilst labor supply in India is large, only part of this can be absorbed into India’s fast-growing service sector, as the business relevance of education as well as the digital preparedness of India’s labor force is low (Chart 6).​​​​​​​   Job losses in the informal sector: According to the Centre for Monitoring Indian Economy (CMIE), a private firm, India’s unemployment rate was recorded at 11.9% as at June 1, 2021. Even before the second COVID-19 wave and related lockdowns began, this metric was recorded at an elevated level of 7.5% over Dec 2020 to Feb 2021. Most of the job losses that have occurred are likely to be concentrated in the informal or unorganized sector, which employs 80% of India’s workforce. Rural wage inflation collapse points to excess supply: The supply of labor in the informal sector has increased at a faster pace than demand as evinced by the slowdown in rural wage inflation in India from an average of 12% over 2008-19 to 5% over 2019. This dynamic has worsened amid the pandemic as rural wage inflation fell to 2% in 2021YTD. This is after a challenging 2020 when unorganized sector wages could have contracted by 22%, according to a study conducted by the International Labor Organization (ILO). Informal sector’s market share loss suggests demand may stay weak: The Indian economy over the last five years has been undergoing a rapid pace of formalization. This was triggered by government action including the “de-monetization” move in 2016 (which outlawed high denomination notes that were in circulation) and then the introduction of the goods and services tax regime in 2017 (which discourages businesses from working with informal, non-tax paying businesses). The trend of formalization was then cemented in the pre-pandemic years by the fact that the economic health of the informal sector’s consumer was worsening. The formal sector on the other hand caters to a relatively high-income consumer whose incomes/jobs grew at a steady clip. The pandemic expedited this trend of formal sector businesses gaining market share as access to finance from unorganized sources either dried up or became prohibitively expensive, thereby leading to another wave of causalities in the informal sector. Also, it is worth noting that formal sector businesses tend to be more efficient and need fewer hands to generate each unit of profit so even as this sector grows it needs fewer workers. This trend of formalization has been particularly true for the retail, financial, building materials and real estate sectors in India, where the informal sector has shrunk and left behind a trail of job losses. Bottom Line: India’s growth prospects in FY22 could disappoint. With government finances strained and private demand weak, investment growth in FY22 is likely to decelerate. Additionally, employment growth is likely to stay low, especially for informal workers, as the economy rapidly formalizes. Given that wage growth has not slowed down for the top income strata as much as for the bottom, it is this top income group’s consumption growth which is likely to support consumption in FY22. However, the bulk of household consumption will falter. The interplay of these forces will mean that the two prime drivers of India’s growth engine, consumption and investment, will stay constrained in the short run. In view of these factors, we highlight the risk of India’s GDP growth rate in FY22 undershooting the Indian central bank’s forecast of 10.5% by 200-350bps. Now it is tempting to think that even a 7.5% real GDP growth rate appears decent compared to peers. But it is critical to note that India’s headline GDP growth data in FY22 has an unusual padding built into it. Strong low base effect: Whilst emerging markets’ GDP growth contracted by 2.2% in 2020 as per IMF, India’s GDP contracted by 7.3%. So, the contraction experienced by India in 2021 was 3x times more than that experienced by peer countries. FY22 GDP comparison with FY21 makes growth appear high, when it is not: If India’s GDP growth rate in FY22 were to be recorded at 8%, then this would in fact imply no growth over the real GDP recorded in FY20. COVID-19 Effect: The Road To Economic Normalcy Will Be Long Whilst the second wave of the pandemic has peaked in India, the time required for this peak to turn into a trough could take longer than was the case last year. Furthermore, India’s slow vaccine roll-out (particularly in India’s large states) adds to the probability of a potential third wave. The Second Wave In India Was 3.6 Times Stronger Than First Chart 7Second COVID-19 Wave Was 3.6x Stronger The virus in the second wave has been far more virulent and necessitated another wave of lockdowns. In specific, the peak COVID-19 deaths during the second wave were recorded at 4,188 deaths per day (on a 7-day moving average basis), which is 3.6 times greater than the peak hit last year (Chart 7). Also, a range of sources2 suggest that actual daily deaths in India could be 1.5-2x the stated numbers. Given that this wave has been stronger, the journey to the trough too is likely to be longer and thus may need localized lockdowns to stay in place. Headline Vaccination Rates Hide Vast Regional Disparities Only 15% of India’s population has received at least one dose. Headline vaccination rates conceal the slow pace of vaccination underway in some of India’s largest states (Chart 8). For instance, less than 8% of the population has been given its first dose in India’s most populous state (i.e. Uttar Pradesh). Given that state borders are porous, persistently low vaccination rates in large states can allow the virus to spread and mutate. Chart 8India’s Largest States Are Lagging On Vaccinations Even today only 3% of India’s population has received both doses of vaccines. Even as the government plans to vaccinate all of India’s adult population by December 2021, this goalpost could have to be shifted to early 2022. A Loaded State Election Calendar Cometh In 2022 Looking into 2022, the state election calendar will get busier than it was this year. This could be a problem if vaccination rates are slow because elections involve large-scale rallies and gatherings. It is worth noting that: Five state elections that account for about 20% of India’s population were held in 2021. Elections will be due in seven states that account for about 25% of India’s population in 2022. To provide context, the population involved in state elections in India in 2021 was almost equivalent to that of a national election in Brazil. The states in India undergoing elections in 2022 have a population comparable to the United States. Besides involving a larger population, state elections due in 2022 will also have higher political stakes. This is mainly because in five of the seven states, the ruling Bharatiya Janata Party (BJP) is the incumbent party and will want to defend its status. This contrasts with the 2021 elections when the BJP was the incumbent in only one of the five states. In specific, India’s most populous state, Uttar Pradesh, is scheduled to undergo elections in February 2022. This is easily the most important state election in India and will be a high stakes four-cornered contest. Vaccine rates in this state are currently lagging the national average. Bottom Line: During the first wave, it took about five months for the trough to form after the peak in September 2020. The current wave has been significantly stronger (causing 4x more deaths) with vaccine rates too being low. Therefore, this wave may take longer than 5-6 months to subside. The long road to the trough in turn implies that the road to economic normalcy too may be slower than anticipated. Investment Takeaways Chart 9India's Outperformance Since March 2020 - Driven More By P/E Expansion, Less By Earnings The Indian stock market has outperformed relative to emerging markets (Chart 9). Given that we are increasingly worried about India’s growth capabilities, we will close our Long Indian / Short Chinese Equities trade for a gain of 11.7%. Tactically, excessive policy tightening remains a genuine risk for the Chinese economy. Incidentally, we also expect that the looming US-Iran diplomatic détente will weigh on bullish fundamentals for oil in the second half of the year, which would be good for Indian stocks. However, the pair trade is challenged from a technical perspective and so we will book gains and move to the sidelines for now. Moreover to mitigate the effects of the coming growth slowdown in India on client portfolios, we recommend initiating two sectoral trades, namely Short India Banks and Long India Consumer Discretionary.  Our Emerging Markets Strategy has shown that Indian private banks have higher efficiency and better balance sheets vis-à-vis EM banks. Our concern is that markets have already priced this dynamic. Specifically, Indian banks’ return on equity has seen a sharp drop from pre-pandemic levels and yet valuations remain high (Chart 10). As GDP growth in India slows, credit growth will stay low. This along with rising domestic interest rates could mean that banks’ net interest margins disappoint. As India’s broader consumption story disappoints and a K-shaped recovery takes shape, we expect a limited set of high-income services and business sector professionals to drive demand for high end-consumer discretionary products. So these two sectoral trades tap into the differential growth rates that two different segments of the economy are set to experience. Finally, we recommend closing the Long Indian Local Currency Bond / Short EM Bonds trade which is currently in the money. This is for two sets of reasons. Firstly, history points to a tight correlation between the US 10-year bond yield and Indian local currency denominated 10-year bond yields. As the US 10-year yield moves upwards, we expect Indian yields also to inch higher. Secondly, we worry that India’s fiscal response to the pandemic has been relatively small thus far and so India could opt for an unexpected expansion in its fiscal deficit over the next 12 months (Chart 11). Chart 10Indian Banks Appear To Be Factoring In All Positives Chart 11India’s Fiscal Response To The Pandemic Has Been Relatively Small So Far ​​​​​​​ Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com     Footnotes 1Daron Acemoglu and James Robinson, Why Nations Fail: The Origins of Power, Prosperity, and Poverty (New York: Crown, 2012) 2Please see Jeffrey Gettleman, Sameer Yasir, Hari Kumar, and Suhasini Raj, “As Covid-19 Devastates India, Deaths Go Undercounted,” New York Times, April 24, 2021, nytimes.com and Murad Banaji, “The Importance of Knowing How Many Have Died of COVID-19 in India,” The Wire, May 9, 2021, science.thewire.in.

On Friday 4th June, I will be debating my colleague Peter Berezin on the future of cryptocurrencies. I believe that the cryptocurrency asset-class has substantial further price upside, whereas Peter thinks that it is going to zero. So please join us for what will be a lively debate on Friday 4th June at 10am EDT, (3pm BST, 4pm CEST). Dhaval Joshi Feature Chart of the WeekThe Fractal Structure Of Cryptos Had Become Very Fragile Today’s report is a brief review and update of the 22 short-term trades that we have recommended through the past three months, and it demonstrates the power of Fractals: The Competitive Advantage In Investing. At the end of the report we also introduce a new trade. Our 22 recommendations have comprised 10 structured trades – which include profit-targets, symmetrical stop-losses, and expiry dates – plus a further 12 recommendations without structured exit points. In summary, three structured recommendations have hit their profit targets: short NOK/PLN +2.6 percent, long European Personal Products versus Autos +15 percent, and long Finland versus Sweden +4.7 percent. Two open trades are in profit, and one is flat. Against this, two structured recommendations hit their stop-losses: short GBP/JPY -2.2 percent, and long New Zealand versus MSCI ACWI -4 percent. Meanwhile, long China versus Netherlands reached its expiry date at a slight loss -1.8 percent. And one open trade is in loss. This results in a ‘win ratio’ at a commendable 55 percent – counting a ‘full win’ as hitting the profit target, a ‘full loss’ as hitting the symmetrical stop-loss, and pro-rata for partial wins and losses. The win ratio at 55 percent is commendable because, in recent months, all financial assets been strongly correlated to the ebb and flow of bond yields and the ‘reflation trade’ – as we highlighted in The Pareto Principle Of Investment. This has made the current environment a difficult one to find genuinely independent investment ideas. Even more commendably, the 12 unstructured recommendations, which included Bitcoin, Ethereum, and several commodities, have all anticipated exhaustions or sharp reversals. The sections below review the structured and unstructured recommendations in chronological order. The 10 Structured Recommendations 1.            18th March: Short NOK/PLN                 Achieved its +2.6 percent profit target. 2.            25th March: Short GBP/JPY                 Hit its -2.2 percent stop-loss. 3.            1st April: Long European Personal Products vs. European Autos                 Achieved its +15 percent profit target. 4.            15th April: Long China vs. Netherlands                 Expired at -1.8 percent (versus its +5 percent profit target). 5.            15th April: Long Finland vs. Sweden                 Achieved its +4.7 percent profit target. 6.            22nd April: Long New Zealand vs. MSCI ACWI                 Hit its -4 percent stop-loss. 7.            6th May: Short Building and Construction (PKB) vs. Healthcare (XLV)                 In profit, and we expect further upside (Chart I-2). Chart I-2Short Building And Construction Versus Healthcare 8.            6th May: Short France vs. Japan                 In loss, but we expect upside. 9.            13th May: Long USD/CAD                 Flat, but we expect upside. 10.          20th May: Long 10-year T-bond vs. 10-year TIPS                 In profit, and we expect further upside (Chart I-3). Chart I-3Short Inflation Expectations The 12 Unstructured Recommendations 1.            18th March: Stocks vs. Bonds (MSCI ACWI vs. 30-year T-bond) to consolidate                 As anticipated, global stocks have consolidated versus bonds since mid-March, and we expect the consolidation to continue. 2.            18th March: Long 30-year T-bond                 Likewise, exactly as anticipated, bond prices have rebounded since mid-March, and we expect the rebound to continue (Chart I-4). Chart I-4Bond Prices To Rebound 3.            25th March: Tactically short Bitcoin                 Bitcoin subsequently corrected by almost 40 percent, but the correction is mostly done (Chart I-1).   4.            25th March: Tactically short Ethereum                 Likewise, Ethereum subsequently corrected, but the correction is mostly done. 5.            15th April: Short Taiwan vs. China                 Taiwan subsequently corrected versus   China, but the correction is mostly done. 6.            22nd April: Short PKR/USD                 As anticipated, PKR/USD corrected in the subsequent month. 7.            6th May: Short Corn vs. Wheat 8.            6th May: Short Timber (Chart I-5) Chart I-5Short Timber 9.            13th May: Short Soybeans 10.          20th May: Short Copper 11.          20th May: Short Tin 12.          27th May: Short Iron Ore                 As anticipated, all the above commodities have corrected, and in some cases very sharply. But the correction is still underway. New Recommendation Finally, this week’s new recommendation comes from the MSCI world equity index universe. The massive outperformance of Austria versus Chile – in large part due to the different sector compositions of the two markets – is fragile on all fractal dimensions: 65-day, 130-day, and 260-day (Chart I-6). Chart I-6Short Austria Vs. Chile Accordingly, the recommendation is to short Austria versus Chile, setting the profit target and symmetrical stop-loss at 7 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart I-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart I-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields ##br##- Asia Chart I-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Highlights President Biden’s FY2022 budget largely confirms consensus views of the economy – which means that it overrates the government’s tax-collecting powers and underrates its fiscal profligacy. The US fiscal thrust will turn negative as the budget deficit contracts in the coming years but the private economic recovery looks robust and positive government spending surprises will mitigate the fiscal cliff. The Biden administration may attempt to pass its capital gains tax hike in the next budget reconciliation bill and make it retroactive to 2021. We doubt this will occur but investors will need to book some profits to be on the safe side. Big Tech still faces a “slow boil” when it comes to government regulation. Stay long materials and infrastructure relative to tech. We were stopped out of our long energy large caps trade. The energy sector is still a beneficiary of a strong macro backdrop for oil and commodities. Close our long municipal bonds trade for a gain of 2%. Feature President Biden’s budget proposal for fiscal 2022 is a confirmation of macro policy trends that the market is well aware of and has already priced. The presidential budget, released on May 27, is a symbolic document. Congress controls the purse strings and congressional dynamics will work out differently from what the White House intends. Still, the budget is significant for highlighting the administration’s big spending preferences and the critical structural theme: the return of Big Government. That is not to say that Biden will fail to overcome various checks and balances with regard to his major legislative priorities, the American Jobs Plan (AJP) and American Families Plan (AFP). Biden’s measurable political capital is still moderate-to-strong. His popular approval remains above 50% and slightly improved in the latest opinion surveys (Chart 1). It should stay above the halfway line as the economy recovers. Chart 1ABiden’s Approval Rating Holding Up Chart 1BBiden’s Approval Rating Holding Up Consumer confidence improved again in May, on the back of what promises to be a rollicking disease-free summer for households. Political polarization continued to abate in the wake of the contested 2020 election. It may be hitting resistance levels (we expect polarization to remain elevated despite dropping off from Trump-era peaks) but the market implications will only become relevant after Biden’s legislative agenda grinds to a halt following the passage of his second reconciliation bill. Polarization will revive around September with the debt ceiling and the 2022 budget appropriations process and ahead of the 2022 midterm elections, which have a subjective 75% chance of gridlocking Congress. But that time has not yet come and Biden is still capable of signing one or two major bills into law. New data on government spending underscores the big government trend. Fiscal thrust – in this case the unadjusted change in the budget deficit – grew substantially in the first quarter of 2021 relative to the fourth quarter of 2020. It went from 4.6% of GDP in Q4 to 13.1% of GDP in Q1, an increase of 8.5%. The budget deficit will contract in the coming years, a headwind for the economy, but not too dangerous of a headwind as long as the private economy continues to recover, as it should. Real wages are growing at a steady pace, leaping up from a 1.9% growth rate in November to 11.7% in April. What is more notable is the continued decline in consumer loan delinquencies from 1.8% to 1.7% in the first quarter – i.e. flat and marginally declining. It is impressive that the US suffered a recession without considerable consumer or business bankruptcies or delinquencies. When government support ends – when the moratorium on home evictions expires this month and unemployment insurance dries up in September 6 – it will be critical to watch for an increase in distress to determine if the Fed will become more or less inclined to taper asset purchases, the preliminary to raising interest rates. Given that the pandemic caused the recession, and that the pandemic is ebbing on the back of vaccinations, our base case is that the private economy will recover even as government support declines. Most of the good news of the US recovery and government stimulus is priced into the market. Investors will now focus on the Federal Reserve and the passage of Biden’s two big bills. We agree with the BCA House View that the Fed will deliver dovish surprises despite the improving economy as it cannot afford to renege on its new monetary policy strategy but must convince the market that it remains dedicated to an inflation overshoot. Biden’s Budget In A Few Simple Charts Biden’s first presidential budget projects a sea change in US government spending, a “normalization” in US government taxation (reversal of President Trump’s tax cuts), and an economy whose underlying conditions remain the same despite the policy sea change. In reality the economy will respond to the sea change in policy. Real economic growth is projected to slow from 5.2% this calendar year to 4.3% in 2022 and then to settle at around 2% through 2031 (Chart 2). This is in line with forecasts from the Congressional Budget Office and consensus expectations of potential GDP growth. Productivity and labor force growth, which make up potential GDP, are hard to predict. We would note that the Biden administration has drastically cut back on immigration law enforcement. It will be hard to dislodge the Democrats in 2024 given that the economy will be robust and the Republican Party is divided. Therefore immigration policy will not undergo a substantial tightening at least through 2028, though bipartisan immigration reform is possible after 2022 and would marginally tighten inflows. Chart 2Presidential Budget Growth Rate Assumption Meanwhile a substantial increase in federal funding for infrastructure, research and development, and STEM education could improve productivity later in the decade, if only on a cyclical rather than structural basis. In other words the administration is not too optimistic regarding growth assumptions even though it assumes higher growth than the Fed or CBO. Inflation is expected to peak at 2.3% in 2025 and continue at that rate throughout the decade (Chart 3). We will not enter into the inflation debate here. Suffice it to say that the risk lies to the upside despite the above points regarding potential growth. Republican voters have abandoned any semblance of fiscal austerity, as signified by President Trump’s success, while the Democrats under Biden are flirting with modern monetary theory. The Fed has adopted a new monetary policy that is aimed at fighting deflationary tail risks at all costs. The budget deficit and trade deficit are ballooning and the US dollar is weakening. The US has fundamentally shifted trade policy, at least with regard to China, which is pushing up input costs. Chinese and global demographics imply a falling ratio of workers to dependents, which implies a secular rise in wages. Chart 3Presidential Budget Inflation Assumption In terms of taxing and spending, the presidential budget is overly optimistic about the ability of the federal government to maintain policy orthodoxy. Budgetary receipts are expected to rise on Biden’s tax hikes and the expiration of the Trump tax cuts in 2025. This is exaggerated, since Biden has already said he will accept a corporate tax hike half as large as that in the budget (25% instead of 28%). It is true that finding the votes to extend the Trump tax cuts will be politically difficult and the expiration date arrives at the beginning of a new administration in a non-election year when some fiscal tightening is manageable. But the projection that spending will stay stable at less than 25% of GDP despite Biden’s “Great Society”-style spending is infeasible (Chart 4). Chart 4Presidential Budget Tax-And-Spend Assumptions Major spending cuts are far less likely in the foreseeable future than they were back in 2011, when the Budget Control Act was passed. True, Republicans will rediscover their fiscal rectitude in the opposition. But in a social environment of populism and anti-austerity they will either fail to obtain full control of Congress or they will fail to execute deep spending cuts. The party’s political base is now the working class so it will have to rethink cuts to entitlements (mandatory spending), just as it is already rethinking its commitment to corporate tax cuts. Democrats will not cut mandatory or non-defense discretionary spending and will oppose any Republican efforts aggressively (Chart 5). Chart 5Presidential Budget Mandatory Versus Discretionary Spending While the presidential budget envisions stable defense spending, the truth is that the one area where Republicans are likely to succeed in influencing fiscal policy substantially lies in defense, which will grow. The US is phasing out its “small wars” and focusing on struggle among the Great Powers. Biden anticipates that defense spending will be flat while non-defense rises sharply but this is unlikely to occur. Regardless of Biden’s specific budget, the US is engaged in the largest government spending since the 1940s and yet there is neither a Great Depression nor a World War II taking place. However, this extravagant peacetime spending looks less extravagant when one considers that there are some historical parallels to the 1930s-40s. There have been two major economic shocks over the past 13 years and there is an emerging cold war with China. The US public has taken a populist turn, the political establishment is determined to provide more largesse to win back the hearts and minds of the people, and the defense and intelligence establishment are well aware of the rising security threats from China and Russia. Federal spending will persistently surprise to the upside while tax hikes could be stymied as early as the 2022 midterm elections. The result is a larger-than-expected budget deficit. The implication for the short-to-medium term is higher inflation and a weaker US dollar. But soaring geopolitical conflict and China’s structural slowdown will eventually put a floor under the dollar. Fiscal Thrust And Budget Deficit Projections Financial markets are already pretty well aware of these trends. The FY2022 presidential budget, which assumes that Biden’s entire legislative agenda passes Congress, does not project a budget deficit that is very different from a back-of-the-envelope “Status Quo” scenario, which assumes that the American Jobs and Families Plans do not pass (Chart 6). Chart 6Presidential Budget Deficit Scenario Alongside Previous Scenarios Of course, the AJP, at least, is likely to pass. If a bipartisan deal is struck this week or shortly thereafter then full passage is possible by the end of July. The Democrats would then spend the entire fall legislative session crafting a bill that combines some of the remaining portions of the AJP with the high-priority parts of the AFP into a single budget reconciliation bill that would be likely to pass by Christmas or early 2022. Nevertheless Biden’s budget reveals that there is not much distance in budget deficit projections with regard to the AFP (Chart 7). Even though the price tag of the AFP is huge, at $1.8 trillion, the truth is that it will be watered down in negotiation and it will also be accompanied by at least some tax hikes. Thus the market already has most of the information it needs regarding US budget deficit projections. Everything else depends on events in the private economy and external sector. The good news of the US budget deficit blowout is largely priced. Future upward surprises in the deficit, which we expect, serve to mitigate the contraction in the budget deficit, i.e. to reduce the negative fiscal thrust that drags on the economy as stimulus wanes. In other words the looming “fiscal cliff” is probably overrated from an economic point of view even though it may contribute to a pullback in the stock market. Chart 7Small Difference Between Biden’s Two Plans Changes In The Post-Infrastructure Agenda After Biden passes his infrastructure plan (the AJP), whether via bipartisanship or reconciliation, the AFP presents a much tougher political slog in Congress. The revised AFP promises to be a Frankenstein monster of social spending – a new “Alphabet Soup” of government programs including affordable child care, elderly care, universal pre-kindergarten schooling, subsidized community college, and paid leave. It will have to be pared back somewhat to appease moderate Democratic senators. The administration has tried to pitch the new social spending as “human infrastructure,” since infrastructure is more popular than welfare, but while Democrats accept this rhetorical gimmick, a majority of independent voters (along with opposition Republicans) apparently do not (Chart 8). Still the AFP could very well pass before the midterm on the condition that Biden signs the AJP this summer. We stick with our 50/50 odds for now. Chart 8Much Tougher Slog On Social Spending Bill The presidential budget introduced a new risk regarding the impending capital gains tax hike: the possibility that it will be enacted retroactively, taking effect in 2021, rather than in 2022 or thereafter as expected. The administration proposes to raise the long-term capital gains rate to 39.6%, which, combined with the Obamacare surtax of 3.8% would result in a 43.4% rate on capital gains for investors making over $1 million. A compromise will be necessary but the top rate could still end up above 32%. If Biden completes a bipartisan infrastructure deal this summer then he is much more likely to get this and other individual tax hikes into the reconciliation bill at the end of this year. Retroactivity is possible but it would be bad politics ahead of the midterm election. Therefore we stick with our view that individual tax hikes will take effect in 2023 if at all. But from a prudential perspective, investors will have to book some gains to prepare for negative tax surprises and that suggests near-term profit taking could weigh on the stock market (Chart 9). Chart 9A Retroactive Capital Gains Tax? Since Biden is guaranteed to get a lot of spending through two or three reconciliation bills (one already passed), he will not get much when it comes to regular appropriations. We are more likely to see the GOP refuse to cooperate on budgetary appropriations. This could lead to a debt ceiling crisis and government shutdown at the end of this year or early next year; hence the aforementioned return of polarization. However, these events will play out very differently from 2011-13. The GOP must tread carefully as they are already divided among pro-Trump and anti-Trump factions and will suffer even worse in public support if they induce a shutdown. A government shutdown would not be market negative in an already highly stimulated economy but it could jeopardize Republican odds in 2022, thus marginally increasing the risk of upward surprises in Democrats’ tax-and-spend policies. Congress is also moving forward on a raft of other legislative proposals, highlighted in Table 1. Most of these proposals will fall short of the bipartisan support necessary to get the required 60 votes in the Senate. The most promising bills involve efforts to resurrect US industrial policy, research and development, technological leadership (particularly in semiconductors), supply chain resilience, and domestic manufacturing. Anything that aims to coordinate the two parties in the face of geopolitical competition with China is likely to pass, as we have highlighted in our sister Geopolitical Strategy service. The result, as mentioned above, is likely to be a cyclical uptick in productivity (we will not speculate here on whether the structural downtrend will be broken). Table 1Pending Legislation In Congress Under Biden The Slow Boil Of Tech Regulation In a recent report on the Biden administration’s regulatory threat to the tech sector we argued that while popular opinion and government interest were creating a “slow boil” for Big Tech, nevertheless the reflationary macroeconomic backdrop posed a much larger short-term risk. We stand by this view especially in light of recent developments. In particular, legislative priorities, gridlock in all key agencies, slow movement in the Department of Justice’s staffing, an evenly divided Senate, and a recent Supreme Court judgement against the Federal Trade Commission all lend confirmation to our thesis, at least for now. To elaborate: A bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart 10) and this consensus grew substantially over the controversial 2020 political cycle. However, not all surveys show strong majorities in favor of regulation, even if they show strong majorities are skeptical of Big Tech’s influence. And Republicans and Democrats disagree on the aims of regulation, with Republicans averse to “content moderation,” or ideological censorship, and Democrats eager to retain their advantage in political fundraising from Silicon Valley. Any bill requiring 60 votes in the Senate would be an opportunity for Republicans to demand that their speech and press rights be preserved, which would be a poison pill for Democrats. The lack of cooperation on the proposed commission to investigate the January 6 riot at the US Capitol highlights the inability to bridge the ideological gap. Chart 10Bipartisan Consensus On Tech Regulation Most of the Democrats’ political capital will be spent on passing the infrastructure bill and the next budget reconciliation bill. There is limited space for other legislation, aside from the strategic competition with China. Minnesota Senator Amy Klobuchar’s anti-trust efforts, including parts of the Competition and Antitrust Enforcement Reform Act, have some chance of passage. She has proposed steps that Republicans can agree on, such as increasing fees on big mergers to fund anti-trust agencies, preventing anti-competitive pricing, and protecting whistleblowers. Her main bill avoids the debate over censorship and arguably preserves the almighty “consumer welfare” standard for determining where harm has occurred and government intervention may be necessary. Republican Senator Mike Lee of Utah has said some positive things about the bill and argues that it would not replace consumer welfare (though not all Republicans will agree and the judicial system will separately defend the consumer welfare standard). Regulatory reform is far more effective when backed by a new legislative overhaul. For example, reform of Section 230 of the Communications Decency Act becomes more difficult without new legislation. Regulation via the executive branch can be important but requires focus from the president and a strong consensus in key positions in the bureaucracy. Democrats must confirm two nominations to the Federal Communications Commission, which is currently deadlocked, in order to achieve a partisan majority and make headway on policy priorities (Table 2). Cybersecurity, net neutrality, and overseeing broadband internet expansion will compete with any regulatory probes into Big Tech. The Senate will also have to confirm two nominations for the Federal Trade Commission, which is also deadlocked at the moment (Table 3). One of these, for anti-trust scholar Lina Khan, a critic of Big Tech, is in process. Yet the FTC has possibly lost some of its bite after a Supreme Court ruling in April (AMG Capital v. FTC) determined that the agency cannot seek monetary relief under one of its most frequently used legal authorities (Section 13b of the Federal Trade Commmission Act). The FTC will thus lose some ability to impose penalties, particularly in consumer protection cases. Facebook is already attempting to use this ruling to dismiss the FTC’s case against it, which could result in a forced sale of popular subsidiaries WhatsApp and Instagram. Table 2Balance Of Power On The FCC Table 3Balance Of Power On The FTC As for the Department of Justice, while Biden’s appointments have all been confirmed, the anti-trust division is bogged down by ethics concerns since several officials would have to recuse themselves in cases against Big Tech due to their previous work representing plaintiffs against Big Tech. The bottom line is that Big Tech is in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as Big Banks faced tougher regulation in the wake of the subprime mortgage crisis. Both public and government willingness to prosecute and regulate Big Tech have gone up, creating a permanently higher level of regulatory risk. Yet government focus and capability are lacking in the short run. Investment Takeaways Most of the major reflation trades have taken a pause in recent weeks, as expected. The stock-to-bond ratio has stalled, the cyclicals to defensives ratio has peaked twice, and TIPS have lost momentum relative to duration-matched nominal treasuries. The big five tech firms’ shares have tentatively arrested their fall relative to the other 495 companies on the S&P500. It is not clear if they will break down further but the above analysis suggests that they will. We are sticking with our long materials / short tech trade (Chart 11). Chart 11Long Materials Versus Technology Investors should stay invested, maintain pro-cyclical trades, favor value stocks relative to growth stocks, but avoid taking on large new risks in the current environment. The post-vaccine rally has lost steam but the overall macro backdrop remains favorable as the global economy recovers. We are closing our long municipal bonds trade for a gain of 2.3%. Our large cap energy trade has stopped out at -5% with small caps outperforming in the face of regulatory and ESG headwinds for the supermajors. Biden’s regulatory risk to energy small caps has been outweighed by the macro context but will become relevant at some point.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets  

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