Sectors

Highlights Going into the new crop year, we expect the course of the broad trade-weighted USD to dictate the path taken by grain and bean prices (Chart of the Week). Higher corn stocks in the coming crop year, flat wheat stocks and lower rice stocks will leave grain markets mostly balanced vs the current crop year.  Soybean stocks and carryover estimates from the USDA and International Grains Council (IGC) are essentially unchanged year-on-year (y/y). In the IGC's estimates, changes in production, trade, and consumption for the major grains and beans largely offset each other, leaving carryovers unchanged. Supply-demand fundamentals leave our outlook for grains and beans neutral.  This does not weaken our conviction that continued global weather volatility will tip the balance of price risk in grains and beans over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. We believe positioning for higher-volatility weather events and a lower US dollar is best done with index products like the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation.  Feature Chart of the WeekUSD Will Drive Global Grain Markets Chart 2Opening, Closing Grain Stocks Will Be Largely Unchanged Going into the new crop year, opening and closing stocks are expected to remain flat overall vs the current crop years, with changes in production and consumption largely offsetting each other in grain and bean markets (Chart 2).1 This will leave overall prices a function of weather – which no one can predict – and the path taken by the USD over the coming year. The IGC's forecast calls for mostly unchanged production and consumption for grains and beans globally, with trade volumes mostly flat y/y. This leaves global end-of-crop-year carryover stocks essentially unchanged at 594mm tons. The USDA expects wheat ending stocks at the end of the '21/22 crop year up a slight 0.5%; rice down ~ 4.5%, and corn up ~ 4%. Below we go through each of the grain and bean fundamentals, and assess the impact of COVID-19 on global trade in these commodities. We then summarize our overall view for the grain and bean complex, and our positioning recommendations. Rice The IGC forecasts higher global rice production and consumption, and, since they expect both to change roughly by the same amount, ending stocks are projected to remain unchanged in the '21/22 crop year relative to the current year (Chart 3). The USDA, on the other hand, is expecting global production to increase by ~ 1mm MT in the new crop year, with consumption increasing by ~ 8mm MT. This leaves ending inventories for the new crop year just under 8mm MT below '20/21 ending stocks, or 4.5%. Chart 3Global Rice Balances Roughly Unchanged Corn The IGC forecasts global corn production will rise 6.5% to a record high in the '21/22 crop year, while global consumption is expected to increase 3.6%. Trade volumes are expected to fall ~ 4.2%, leaving global carryover stocks roughly unchanged (Chart 4). In the USDA's modelling, global production is expected to rise 6.6% in the '21/22 crop year to 1,195mm MT, while consumption is projected to rise ~ 2.4% to 1,172mm MT. The Department expects ending balances to increase ~ 11mm MT, ending next year at 291.2mm MT, or just over 4% higher. Chart 4Corn Balances Y/Y Remain Flat Wheat The IGC forecasts global wheat production in the current crop year will increase by ~ 16mm MT y/y, which will be a record if realized. Consumption is expected to rise 17mm MT, with trade roughly unchanged. This leaves expected carryover largely unchanged at ~ 280mm MT globally (Chart 5). The USDA's forecast largely agrees with the IGC's in its ending-stocks assessment for the new crop year. Global wheat production is expected to increase 16.6mm MT y/y in '21/22, and consumption will rise ~ 13mm MT, or 1.7% y/y. Ending stocks for the new crop year are expected to come in at just under 292mm MT, or 0.5% higher. Chart 5Ending Wheat Stocks Mostly Unchanged Soybeans Both the IGC and USDA expect increases in soybean ending stocks for the '21/22 crop year. However, the USDA’s estimates for ending stocks are nearly double the IGC projections.2 We use the IGC's estimates in Chart 6 to depicts balances. USDA - 2021/22 global soybean ending stocks are set to increase by ~3 mm MT to 94.5 mm MT, as higher stocks from Brazil and Argentina are partly offset by lower Chinese inventories. US production is expected to make up more than 30% of total production, rising 6% year-on-year. Chart 6Higher Bean Production Meets Higher Consumption Impact Of COVID-19 On Ags Trade Global agricultural trade was mostly stable throughout the COVID-19 pandemic. China was the main driver for this resilience, accounting for most of the increase in agricultural imports from 2019 to 2020. Ex-China, global agricultural trade growth was nearly zero. During this period, China was rebuilding its hog stocks after an outbreak of the African Swine Flu, which prompted the government to grant waivers on tariffs in key import sectors, which increased trade under the US-China Phase One agreement. As a result, apart from COVID-19, other factors were influencing trade. Arita et. al. (2021) attempted to isolate the impact of COVID on global agricultural trade.3 Their report found that COVID-19 – through infections and deaths – had a small impact on global agricultural trade. Government policy restrictions and reduced mobility in response to the pandemic were more detrimental to agricultural trade flows than the virus itself in terms of reducing aggregate demand. Policy restrictions and lower mobility reduced trade by ~ 10% and ~ 6% on average over the course of the year. Monthly USDA data shows that the pandemic was not as detrimental to agricultural trade as past events. Rates of decline in global merchandise trade were sharper during the Great Recession of 2007 – 2009 (Chart 7). Many agricultural commodities are necessities, which are income inelastic. Furthermore, shipping channels for these types of commodities did not require substantial human interactions, which reduced the chances of this trade being a transmission vector for the virus, when governments declared many industries using and producing agricultural commodities as necessities. This could explain why agricultural trade was spared by the pandemic. Amongst agricultural commodities, the impact of the pandemic was heterogenous. For necessities such as grains or oilseeds, there was a relatively small effect, and in few instances, trade actually grew. For example, trade in rice increased by ~4%. The value of trade in higher-end items, such as hides, Chart 7COVID-19 Spares Ag Trade Chart 8Grains Rallied During Pandemic tobacco, wine, and beer fell during the pandemic. This was further proof of the income inelasticity of many agricultural products which kept global trade in this sector resilient. Indeed, the UNCTAD estimates global trade for agriculture foods increased 18% in 1Q21 relative to 1Q19. Over this period, Bloomberg's spot grains index was up 47.08% (Chart 8). Investment Implications We remain neutral grains and beans based on our assessment of the new crop-year fundamentals. That said, we have a strong-conviction view global weather volatility will tip the balance of price risk in grains over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. Weather-induced grain and bean prices volatility is supportive for our recommendations in the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. These positions are up 5.8% and 7.9% since inception, and are strategic holdings for us.   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 US natural gas prices remain well supported by increased power-generation demand due to heat waves rolling through East and West coasts, lower domestic production and rising exports. The US EIA estimates natgas demand for July rose 3.9 bcf/d vs June, taking demand for the month to 75.8 bcf/d. Exports – pipeline and LNG – rose 0.4 bcf/d to 18.2 bcf/d, while US domestic production fell to 92.7 bcf/d, down 0.2 bcf/d from June's levels. As US and European distribution companies and industrials continue to scramble for gas to fill inventories, we expect natgas to remain well bid as the storage-injection season winds down. We remain long 1Q22 call spreads, which are up ~214% since the position was recommended April 8, 2021 (Chart 9). Base Metals: Bullish Labor and management at BHP's Escondida copper mine – the largest in the world – have a tentative agreement to avoid a strike that would have crippled an already-tight market. The proposed contract likely will be voted on by workers over the next two days, according to reuters.com. Separately, the head of a trade group representing Chile's copper miners said prices likely will remain high over the next 2-3 years as demand from renewables and electric vehicles continues to grow. Diego Hernández, president of the National Society of Mining (SONAMI), urged caution against expecting a more extended period of higher prices, however, mining.com reported (Chart 10). We remain bullish base metals generally, copper in particular, which we expect to remain well-bid over the next five years. Precious Metals: Bullish US CPI for July rose 0.5% month-over-month, suggesting the inflation spike in June was transitory. While lower inflation may reduce demand for gold, it will allow the Fed to continue its expansionary monetary policy. The strong jobs report released on Friday prompted markets and some Fed officials to consider tapering asset purchases sooner than previously expected. The jobs report also boosted an increasing US dollar. A strong USD and an increase in employment were negative for gold prices on Monday. There also were media reports of a brief “flash crash” caused by an attempt to sell a large quantity of gold early in the Asian trading day, which swamped available liquidity at the time. This also was believed to trigger stops and algorithmic trading programs, which exacerbated the move. The potential economic impact of the COVID-19 Delta variant is the only unequivocally supportive development for gold prices. Not only will this increase safe-have demand for gold, but it will also prevent the Fed from being too hasty in tapering its asset purchases and subsequently raising interest rates. Chart 9 Chart 10 Footnotes 1     The wheat crop year in the US begins in June; the rice crop year begins this month; and the corn and bean crop years begin in September. 2     Historical data indicate this difference is persistent, suggesting different methods of calculating ending stocks.  The USDA estimates ending stocks for the '21/22 crop year will be 94.5mm tons, while the IGC is projecting a level of 53.8mm.  3    Please refer to ‘Has Global Agricultural Trade Been Resilient Under Coronavirus (COVID-19)? Findings from an Econometric Assessment. This is a working paper published by Shawn Arita, Jason Grant, Sharon Sydow, and Jayson Beckman in May 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story.   Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent.  Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##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 greatest legislative battle of the Biden presidency will unfold between now and the end of the year.   Biden’s bipartisan infrastructure deal is likely to pass the Senate soon but will have to cross several hurdles before passage in the House of Representatives. We maintain our 80% subjective odds that it will pass one way or another. Assuming the infrastructure bill does not fall apart, we will upgrade the odds that Biden’s budget reconciliation bill will pass this fall from 50% to 65%. The latter comprises a nominal $3.5 trillion in social spending and tax hikes that will be watered down and revised heavily by the time it passes, which may take until Christmas. Uncertainty about passage will cause volatility to rise in financial markets. Democrats left the debt ceiling out of their fiscal 2022 budget resolution, which ostensibly means they cannot raise the debt limit via a simple majority but will need 10 Republican senators to join. A bruising standoff will ensue that will add to volatility. Ultimately Republicans will comply as they cannot afford to be held responsible for a default on the national debt. The party is currently unpopular and tarred with accusations of insurrection. If Biden succeeds in passing both bills, US fiscal policy will be frozen in place through at least 2025, though endogenous disinflationary fears will largely be dispelled. Feature The biggest domestic political battle of the Joe Biden presidency is likely to occur between now and Christmas. With a one-seat de facto majority in the Senate, and a four-seat majority in the House, Biden is barely capable of passing his two outstanding legislative proposals. The first of these is the $550 billion bipartisan infrastructure deal, which we have given an 80% subjective chance of passing and which passed the Senate on a 69-30 vote margin as we went to press. The second is the $3.5 trillion partisan reconciliation package, based on the remainder of Biden’s American Jobs and Families Plan, which we have given a 50% chance of passage. We will upgrade these odds to 65% if bipartisan infrastructure does not fall through in the House. Next year will be consumed by campaigning for the 2022 midterms so it will be hard to pass any major legislation with such thin majorities (though bipartisan anti-trust legislation could pass and poses a risk to the equity market). The midterms are likely – though not guaranteed – to result in Republicans taking at least the House. The result will be gridlock in which only the rare bipartisan bill can pass. In other words, after Christmas, Biden’s domestic legislative capability and hence US fiscal policy will likely be frozen in place through 2025. In this report we provide a road map for the budget battle that will define the Biden presidency. Buy The Dip … Unless New Variants Change The Game First, a brief word regarding the COVID-19 pandemic. The Delta variant is ramping up, particularly in states where vaccination rates have lagged and social restrictions are minimal (Chart 1). The new lambda variant is also causing concerns that vaccines may be inadequate. Equity markets could easily suffer more downside in the near term but US-dedicated investors should consider the following: Scientists have created one vaccine for COVID-19 and can create others. There has been a concrete reduction in uncertainty since November 2020. Vaccination rates will never be perfect – many people smoke cigarettes and refuse to wear seat belts! – but greater infection rates and hospitalizations are leading to improvements in vaccination coverage. While new lockdowns are not impossible, the public will only support them as a last resort. Not only is the White House still officially opposed to new lockdowns but also the authority to impose lockdowns rests with governors. If hospital systems are crashing then even Republican governors will endorse new social restrictions. Otherwise, restrictions will not be draconian unless a much more virulent variant emerges (one that is more deadly or that has a worse impact on children). Monetary and fiscal stimulus will ramp up if a new variant is more deadly or the economy otherwise starts to slide back. In the US, additional fiscal stimulus will come faster than in other countries because new short-term measures can easily be tacked onto major bills that are already coming down the pike. Chart 1Stay Constructive Amid Delta Jitters Might the White House leverage a renewed sense of crisis to get its main fiscal bills passed? We can see that. The last thing Biden needs is a sluggish recovery to translate into congressional gridlock in the 2022 midterms – the bane of the Obama administration. Rather, the goal is to harness the sense of crisis to pass stimulus. Biden’s approval rating is falling, as is the norm with modern presidents. However, it is still “above water” (net positive) and still sufficient to get his legislative initiatives across the line. Biden’s forthcoming bills will reinforce economic recovery and sentiment (Chart 2) Chart 2Biden’s Approval Comes Down To Earth What if a variant evades vaccination? Especially if it is more deadly and/or more harmful to children? That would be a game changer and would cause at least a market correction. Still, investors would want to buy the dip given what they know today relative to what they knew in early 2020 (and given that they bought the dip in March 2020 even not knowing what they know today). Bipartisan Structural Reform Our second key view for 2021 – “bipartisan structural reform” – is coming to fruition with the Senate’s 69-30 vote passage of the American Infrastructure and Jobs Act as we go to press. Major bipartisan deals are rare in highly polarized America but we have given an 80% subjective chance of passage to this bill. Passage in the Senate reinforces that view, though the odds of final passage remain the same as there will be hurdles in the House. We include infrastructure as a “structural reform” because of its ability to increase the productivity of an economy. The bill contains funding for traditional infrastructure, like roads, bridges, and ports, as well as non-traditional infrastructure such as subsidies for electric vehicles and high-speed internet (Table 1). Table 1What’s In The Bipartisan Infrastructure Deal? Table 2 shows the 19 Republican senators who voted in favor of this bipartisan deal, along with their ideological ranking and state support rates. This tally provides a nine-seat buffer in case the House version of the bill requires another Senate vote. It also provides a measure of the support that might be brought to bear for bipartisan causes later, such as funding the government, suspending the debt ceiling, or passing bills on popular issues (such as regulating Big Tech) in 2022-24. All Democrats voted in unison for the bill. Table 2Republican Senators Who Voted For Biden’s Bipartisan Infrastructure Bill Our high confidence on infrastructure spending stems both from its popular support (Chart 3) and from the fact that even if bipartisanship fails, there remains a partisan option: budget reconciliation. This is still true today. The bipartisan infrastructure bill could still die in the House, given Speaker Nancy Pelosi’s determination to make its passage contingent on the success of the larger reconciliation bill, which is anathema to Republicans. But if it dies, Democrats would take up the key provisions in the reconciliation bill – and the odds of that bill passing would go up, not down, since Democrats would need to close ranks to clinch a legislative victory ahead of the midterms. Chart 3Popular Support For Bipartisan Infrastructure Deal Thus the real risk is not that infrastructure spending will fail but that its success will reduce the political capital needed to pass the more controversial reconciliation bill, which we discuss below. Over the short and medium term, this bipartisan infrastructure deal emblematizes the sea change in US fiscal policy – the shift against austerity – and thus serves to dispel fears of disinflation. At the same time, the deal epitomizes America’s long-term fiscal predicament. Democrats only want to increase spending while Republicans only want to decrease taxes. The former will not make budget cuts while the latter will not hike taxes. The result, inevitably, is higher budget deficits. This is precisely what occurred with the latest agreement: tax measures to pay for new infrastructure spending are mostly chimerical – the Congressional Budget Office (CBO) estimates that only $200 billion of the new spending will be offset with new revenue. The other $350 billion will add directly to deficits and debt. The difference is small but the political signal is notable. Chart 4 highlights the increase in the deficit likely to occur, with the CBO’s more realistic assessment delineated from the nominal bill. From a macro point of view, the takeaway is that the US economy faces a stark withdrawal of government support in 2022 but this bill slightly cushions the blow. Continued recovery will depend on consumers and businesses (which look to be in good shape). Beginning in 2025 deficits will start to rise again and hence the overall picture is one in which US government support for the economy has taken a step up for the decade. Chart 4Bipartisan Deal Not Paid For = Fiscal Stimulus Side note: Chart 4 is worrisome for President Biden if his reconciliation bill fails, as it points to fiscal drag through 2024, the election year. Bottom Line: We still see an 80% chance that Biden’s infrastructure proposals will pass, as the Democrats have a backup plan if the bipartisan deal somehow collapses in the House. Biden’s Greatest Legislative Battle Up till now we have assigned 50% odds of passage to the subsequent part of the Biden agenda, the American Families Plan, which covers social spending and tax hikes (corporate and individual). If bipartisan infrastructure passes promptly, we would upgrade the reconciliation bill’s odds of passing to 65%. The reason is twofold: first, reconciliation only requires a simple majority consisting of all 50 Senate Democrats plus the vice president; second, hesitant moderate senators ultimately will be forced to recognize that sinking the bill would render the Biden presidency defunct and fan the flames of populist rebellion on both sides of the political spectrum. And yet, since Biden cannot spare a single vote, conviction levels cannot be high. Therefore 65% seems appropriate. On August 9 Senate Democrats presented a $3.5 trillion budget resolution that will form the basis of the reconciliation bill this fall. The bill contains a wish list of spending priorities, as outlined in Table 3. Most of these are familiar from last month when the Senate Budget Committee first put forward its framework. The hang-up stems from House Speaker Pelosi. Knowing that infrastructure’s passage will suck away political capital from social spending, Pelosi is attempting to link the two bills. If the Senate fails to pass the reconciliation bill, the House will not pass the infrastructure bill. This gambit will create a big increase in uncertainty this fall as the legislative battle heats up. Republicans cannot support the infrastructure bill if it is directly tied to the Democrats’ “Nanny State” debt blowout, which will be the basis for their campaign against Democrats in future. They need plausible deniability. If Pelosi insists on linking the two bills, Republican support will evaporate. True, Democrats would then proceed to partisan reconciliation – but they would need to sacrifice other agenda items, such as subsidies for green tech, college, health care, and manufacturing (see Table 3 above). Table 3Senate Democratic FY22 Budget Resolution (July 2021) Biden and the Senate are now united on the infrastructure bill. Biden and Democrats in marginal seats need a legislative victory ahead of the midterms – and a bipartisan victory on a popular policy like infrastructure is critical. A bird in the hand is worth two in the bush. Therefore, Pelosi will probably have to concede, after gaining assurances from moderate Senate Democrats that they will not sink reconciliation. Moderate Democrats, in turn, will need to see the reconciliation bill watered down, both on spending and taxes. Table 4 shows both bills together, as Biden’s “Build Back Better” agenda, with a baseline net deficit impact. Budget deficit scenarios are then updated in Chart 5. Once again what stands out is the large fiscal drag in 2022, the fiscal thrust for the remainder of the decade, and (in this case) minimal fiscal drag for 2024. Table 4Face Value Impact Of Biden’s Spending Proposals Before Congress (Baseline) Chart 5Deficit Scenarios For Bipartisan Infrastructure Deal And Reconciliation Bill This is true even if tax hikes fail to make it into the final reconciliation bill. We still maintain that the corporate tax rate will rise above Senator Joe Manchin’s ideal 25% rate (if not all the way to Biden’s 28%) while individual tax rates will return to pre-Trump levels. It is not clear if capital gains tax hikes will make the final cut. Most likely some tax hikes will occur but they will fall short of Biden’s plan, producing, at most, a one percentage point increase in the budget deficit relative to the Congressional Budget Office’s baseline estimate (Chart 6). Chart 6What Happens If Tax Hikes Fail To Pass Congress? In Table 5 we update our various legislative scenarios, each consisting of different mixes of spending and tax hikes. We assume that the size of the bipartisan infrastructure deal will not be reduced in the House; that the revenue offsets of that deal will be $200 billion maximum; that moderate Senate Democrats will have greater success in watering down tax hikes than spending programs; and that the government overestimates its ability to collect revenue through tougher tax enforcement. Finally we assume that Senate Democrats’ spending proposals will not be cut – an extremely generous assumption that will not hold up in practice. Table 5Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill Each legislative scenario’s impact on the deficit is shown in Table 6. The result is a wide range of deficit impacts, from the baseline of $588 billion to Scenario 6, with $2.59 trillion (zero tax offsets). The more realistic range is from $1 trillion to $2.3 trillion (i.e. all scenarios except the baseline and Scenario 5). Within this range the result depends on the moderate senators’ negotiation skills. Conservatively, the impact will range from $1-$1.5 trillion (Scenarios 1, 2, 4), with moderate senators preventing a $2 trillion price tag as politically impracticable (e.g. Scenario 3). Table 6Scoring Of Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill There are two other aspects of Biden’s massive legislative battle this fall: regular government budget appropriations and the debt ceiling. Government appropriations are supposed to be passed by the end of the fiscal year, September 30, but often run over and likely will this time. Republicans will not support regular spending increases given that Democrats will ram through a partisan spending blowout. Therefore Congress will have to settle for a continuing resolution (a stop-gap measure) that keeps spending levels the same. Otherwise a government shutdown will occur. A shutdown is possible but would weigh heavily on Republicans’ public image, which is already at a low point in recent memory following the scandals of the Trump presidency. That is not all – there is also the debt ceiling (limit on national debt). Democrats made a major gambit by not including a suspension or increase of the debt ceiling in their fiscal 2022 budget resolution. If they had included it, then they could have raised the debt ceiling on their own with a simple majority when they passed their reconciliation bill. Instead they are attempting to make Republicans share the blame. Republicans, however, will mount an aggressive resistance, as they do not want to be seen as authorizing the debt increase necessary to accommodate the Democrats’ “socialist” spending spree. The “X date,” when the Treasury Department runs out of the ability to use extraordinary measures to make payments due on US debt, is expected sometime in October or November, though Treasury Secretary Janet Yellen warns it could come sooner and will try to pressure lawmakers. After this date the US would technically default on national debt obligations, triggering financial turmoil and potentially a global crisis. A debt ceiling showdown is virtually inevitable and volatility will rise – but ultimately a default will be averted, as we outlined in a recent report. First, Democrats still have the ability to revise the budget resolution so as to include a debt ceiling suspension in their final reconciliation bill. While Republicans could arguably block this attempt via a filibuster in the Budget Committee, they would have no interest in doing so (they could abstain and thus keep their hands clean of any debt ceiling increase). Second, Republicans can be forced to agree to a suspension of the debt ceiling when they fund the government, since it is necessary to do so anyway to fund their own infrastructure deal. Suspending the debt ceiling is not the same as raising it. New battles would be set up for later, in 2022 and beyond. But Republicans do not have the political ability to force a default on the public debt of the United States in the same year that Democrats accuse them of raising an insurrection against its Congress. Bottom Line: This fall will see the great legislative battle of the Biden presidency. Infrastructure spending has an 80% chance of passing. Pelosi will not be able to withstand Biden and the Senate in passing this deal separately from the more partisan reconciliation bill. If it passes, then Biden’s reconciliation bill will rise from 50% to 65% odds of passage. The latter will be watered down to a net deficit impact of $1-$1.5 trillion to secure the votes of moderate Senate Democrats, who ultimately will not betray their party to neuter Biden’s presidency. Thin margins in the House and Senate do not permit higher odds of passage or a high level of confidence. Investment Takeaways Political polarization has fallen sharply (Chart 7). This is connected to our view that the Republican Party is split, while Biden’s key initiative (infrastructure) has bipartisan support. However, Biden’s bipartisanship has resulted in a larger loss of Democratic support than a gain of Republican support (Chart 7, bottom panel). And the upcoming reconciliation bill will reignite Republican opposition. Moreover, polarization will remain at historically elevated levels, even to the point of generating domestic terrorist attacks, as we have argued. Biden’s approval rating has fallen but not enough to sink his legislative proposals. The overall economy is strong judging by both consumer confidence (Chart 8) and capital spending (Chart 9). Any soft patch in the economy in the near term will assist Biden in his legislative battles. Passage of either or both major bills will boost his approval rating, potentially ameliorating the Democrats’ challenging situation in the 2022 midterms. Chart 7Bipartisan Biden Lowers Polarization As Dems Waver Chart 8US Consumer Confidence Soars Chart 9US Capital Spending At Peak Levels Still, we expect investors to “buy the rumor and sell the news” of Biden’s upcoming stimulus bills. After the Senate passes the reconciliation measure, investors will have to look forward to the combined impact of tax hikes, the Fed’s tapering of asset purchases and eventual rate hikes, and the various troubles with global growth and geopolitical risk. Until that time, investors must weigh the risks of the COVID-19 variants against actions by both American and Chinese policymakers to dispel deflationary tail risks. Thus for now we are sticking with our key trades of the year: value stocks, materials, and infrastructure plays (Chart 10). After Biden wins his big legislative battles, we will reassess.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 10Buy Rumor, Sell News On Biden Plan   Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model 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    

In this Sector Insight report, we come back to the issue of “how much inflation is too much” for equities. The short answer is – equities don’t mind inflation as long as the Fed does not mind it either. Chart 1 shows historical analysis of forward SPX returns (both real and nominal) using different inflation ranges as a starting point.  Empirically, CPI prints of below 3% do not weigh on market performance.  However, once inflation rises above the 3-4% range, it causes a notable slowdown in returns, and above the 4% mark, it results into negative expected forward returns. Chart 2 is a scatterplot of trailing PE multiples vs core CPI prints.  This chart confirms our initial conclusion that an inflation sweet spot for the equity market is around 2-3% core CPI range: this is the range where equity multiples expand the most. It is also clear from the chart that any higher core CPI values become a headwind for equities. The implication is that the negative forward expected return that we showed on Chart 1 comes from the multiple contraction. Chart 1Moderate Inflation Does Not Have An Adverse Effect On The Performance Of Equities Chart 2High Levels Of Inflation Are Associated With Multiple Contraction Equities are a real asset, and rising inflation does not have a negative effect on the earnings, as most companies are able to pass cost increases to their customers, and strong earnings growth translates into robust equity returns. Inflation is a concern for equity investors only from one angle: higher inflation may provoke the Fed to raise rates, and higher rates do have an adverse effect on the performance of equities. Bottom Line: Our view remains that inflation surge was transitory, but we do believe that the inflation will stay elevated for a while. Yet, if it does not exceed the 3% mark, there will be no negative repercussions for equities if the Fed stays patient.

Foreword Today we are publishing a charts-only report focused on the S&P 500 and its sectors. Many of the charts are self-explanatory; to some we have added a short commentary.  As with the styles Chart Pack, published a month ago, the sector charts cover macro, valuations, fundamentals, technicals, and the uses of cash.  Our goal is to equip you with all the data you need to underpin sector allocation decisions.  We also include performance, valuations, and earnings growth expectations tables for all the styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We plan to update it monthly, alternating sector and style coverage. Overarching Investment Themes Macro Economic surprise index is flagging while Q2-21 earnings surprises are unprecedented.  Much of the good economic news has been priced in and the Citigroup Economic Surprise Index is hovering around zero (Chart 1A).  Most of the economic indicators have turned, confirming that the surge in growth has run its course and the macroeconomic environment is normalizing. Covid-19 fears are resurfacing:  The spread of the Delta variant is unlikely to trigger another lockdown, but consumers may curtail their activities out of fear of infection, adversely affecting demand for goods and services.  However, for now, we are sanguine about this risk. Investors expect inflation to roll over: Investors’ inflation fears are dissipating, attested by the falling 5Y/5Y inflation breakevens (Chart 1B).  Indeed, it appears that the debate on the persistence of inflation has been won by the “inflation is transitory” camp.  Yet, we won’t be surprised if inflation surprises on the upside (no pun intended).  Chart 1AGood Economic News Has Been Priced In Chart 1BMost Investors Are Now Convinced That Inflation Will Be Transitory Labor shortages are starting to dissipate: On the labor front, companies are still struggling to fill job openings.  However, there are signs that the labor market is healing, with more and more workers interested in returning to the labor force  (Chart 2). Inventories will be replenished, spurring investment: Post-pandemic economic recovery is still plagued by the mismatch between supply and demand. Supply-chain disruptions and shortages fail to meet pent-up demand of consumers eager to spend “helicopter drop cash” and accumulated savings.  As a result, inventories have been drawn down, chipping away 1.1% from GDP growth. In fact, they are at all-time lows: Non-farm inventories to final sales have dropped lower than they were during the GFC (Chart 3).  Low inventories will have to be replenished, resulting in further gains in investment and providing a boost to industrial activity going forward. Chart 2More Workers Are Interested In Returning To The Labor Force Demand for services will continue to exceed demand for goods: Last, but not least, consumers have money to spend but are shifting away from goods and toward services and experiences.  Consumer expenditure on goods is above trend and has recently turned down, while spending on services is still below pre-pandemic levels, and rebound is still running its course (Chart 4). Chart 3Inventories Are At All Time Low Chart 4Real Spending On Services Is At PrePandemic Levels: Room For Further Rebound Valuations And Profitability The US stock market remains expensive: The S&P 500 is trading more than two standard deviations above the long-term average.  However, there are pockets of reasonably priced, albeit unloved, stocks within the S&P 500: Telecom (11x forward earnings), Health Care (17x), Energy (14x), and Financials (14x).  Earnings continue to crush expectations: While equities are expensive, they are redeemed by the strong showing of earnings and sales growth reported for Q2-2021.  The scale of earnings beats relative to analyst expectations is spectacular: Running at nearly 20%, or more than two standard deviations above the historical average (Chart 5). Chart 5Earnings Surprises Are Unprecedented Earnings growth is normalizing: Earnings have increased 90% over the lackluster Q2, 2020.  Compared to Q2-2019 as a baseline quarter, earnings are up 22%, pointing to normalization going forward.  Earnings growth will become a tailwind for the outperformance of equities into the balance of the year and will help the S&P 500 to grow into its big valuation “shoes”. Margins are expanding despite inflation:  Many sectors are able to grow earnings and recover margins despite increases in costs of raw materials and labor, thanks to their strong pricing power, i.e., ability to pass on higher input costs to their customers (Chart 6A).  Sectors with the highest pricing power are: Communications Services, Consumer Discretionary, Industrials, Energy and Materials.  They are the best inflation hedges. Chart 6ACompanies' Profitability Is Improving To Pre-Pandemic Levels Uses Of Cash Cash to be disbursed to shareholders: Share buybacks and other shareholder-friendly activities are on the rise again and are expected to gain steam this year and next.  This is supported both by strong earnings growth, healthy balance sheets, and regulatory headwinds to any potential M&A activity due to the anti-trust stance of the current administration Capex is about to make a comeback: Capex is still lagging across most sectors.  A pickup in capex will signal that the post-pandemic recovery is firmly on track, and companies are comfortable investing in future growth.  However, there are early signs that that is about to change.  Philly Fed survey shows that over 40% of respondents are planning to increase their capex expenditure  (Chart 6B). Chart 6BCapex Increases Are On The Way Investment Implications Overweight sectors and industry groups exposed to consumer services spending (airlines, hotels, leisure) and be selective about consumer goods and retailing industry groups: Real PCE for goods has turned down toward the trend line.  Exceptions are areas of the market with well-publicized shortages such as Autos and Parts. Overweight Industrials – US manufacturing has limited capacity, onshoring is a new trend, inventories need to be replenished, and capex intentions are on the rise. Overweight Health Care – growth slowdown favors this defensive sector, which also benefits from a backlog of demand for medical procedures and services. Reflation trade is out of the picture, now that inflation fears have abated and the Delta variant preoccupies investors.  For that, we still favor Growth over Value.  Yet, we watch this allocation closely, to time rotation once Covid-19 fears dissipate, rates pick up and inflation surprises on the upside. With valuations high, and forward returns expectations lackluster, we favor sectors likely to delivery healthy cash yield: Financials, Health Care, Energy, and Technology.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 7Macroeconomic Backdrop And Earnings Surprise Chart 8Profitability Chart 9Valuations And Technicals Chart 10Uses Of Cash Communication Services Chart 11Macroeconomic Backdrop Chart 12Profitability Chart 13Valuations And Technicals Chart 14Uses Of Cash Consumer Discretionary Chart 15Macroeconomic Backdrop Chart 16Profitability Chart 17Valuations And Technicals Chart 18Uses Of Cash Consumer Staples Chart 19Macroeconomic Backdrop Chart 20Profitability Chart 21Valuations And Technicals Chart 22Uses Of Cash Energy Chart 23Macroeconomic Backdrop Chart 24Profitability Chart 25Valuations And Technicals Chart 26Uses Of Cash Financials Chart 27Macroeconomic Backdrop Chart 28Profitability Chart 29Valuations And Technicals Chart 30Uses Of Cash Health Care Chart 31Health Care: Sector vs Industry Groups Chart 32Profitability Chart 33Valuations And Technicals Chart 34Uses Of Cash Industrials Chart 35Macroeconomic Backdrop Chart 36Profitability Chart 37Valuations And Technicals Chart 38Uses Of Cash Information Technology Chart 39Macroeconomic Backdrop Chart 40Profitability Chart 41Valuations And Technicals Chart 42Uses Of Cash Materials Chart 43Macroeconomic Backdrop Chart 44Profitability Chart 45Valuations And Technicals Chart 46Uses Of Cash Real Estate Chart 47Macroeconomic Backdrop Chart 48Profitability Chart 49Valuations And Technicals Chart 50Uses Of Cash Utilities Chart 51Macroeconomic Backdrop Chart 52Profitability Chart 53Valuations And Technicals Chart 54Uses Of Cash  Table 1Performance Table 2Valuations And Forward Earnings Growth Recommended Allocation   Footnotes  

Highlights Investors have grown enamored with online retailers (AMZN), payment processing companies (V, MA, PYPL, SQ), and social media companies (FB, SNAP). All three sectors are likely to experience headwinds over the next 12 months as life returns to normal following the pandemic. Looking further out, market saturation, increased competition, and heightened regulation all pose risks to these sectors. Internet companies in general, and social media firms in particular, will face increased scrutiny not just for their monopolistic practices, but for the mental harm they are causing young people. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. We think there is a 50/50 chance that governments will start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Global Growth Will Remain Above Trend Investors are worried about growth again. Globally, the number of Covid cases is on the rise due to the proliferation of the Delta variant (Chart 1). The ISM manufacturing index dropped to 59.5 in July, down from a high of 64.7 in March. Both of China’s manufacturing PMIs have fallen, with the new orders component of the Caixin index dipping below the 50 line. The European PMIs have also come off their highs (Chart 2). Chart 1Number Of Covid Cases On The Rise Globally Due To The Delta Variant Chart 2Manufacturing PMIs Are Off Their Highs     Growth concerns have registered in financial markets (Chart 3). After climbing to 1.74% in March, the US 10-year Treasury yield has fallen back to 1.22%. Cyclical equity sectors have underperformed defensives. Growth-sensitive currencies such as the Swedish krona and the Australian dollar have weakened. We are more upbeat about global growth prospects than the consensus. As the experience of the UK demonstrates, there is little will to impose lockdowns in countries with ample access to vaccines. Strict social distancing restrictions remain a fact of life in countries lacking adequate vaccine supplies. However, the situation should improve later this year as vaccine production increases (Chart 4). Chart 3Financial Markets Trim Growth Expectations Chart 4Over 10 Billion Vaccine Doses Will Be Produced This Year   Households in developed economies are sitting on US$5 trillion in excess savings, half of which reside in the United States (Chart 5). Inventories are at record low levels, which should support production over the coming quarters (Chart 6). Chart 5Households Flush With Excess Savings Chart 6Record Low Inventories Will Provide A Boost To Production     Chinese policy should turn more stimulative, as the recent cut to bank reserve requirements foreshadows. With credit growth back down to 2018 lows, policymakers can afford to give the economy some juice. The 6-month credit impulse has already turned up (Chart 7). From Goods To Services While global growth should remain well above trend for the next 12 months, the composition of that growth will shift in ways that could meaningfully affect equities. As Chart 8 illustrates, aggregate US consumption has returned to its pre-pandemic trend. However, spending on goods is 11% above trend while spending on services is still 6% below trend. Chart 7Chinese Policy Is Turning More Stimulative Chart 8The Divergence Between Goods And Services Spending   Households typically cut spending on durable goods during recessions, while services serve as the ballast for the economy. The opposite happened during the pandemic. As the global economy recovers, goods spending will slow while services spending will stay robust. This is critical for online retailers such as Amazon, which derive the bulk of their e-commerce revenue from selling goods. Even after its disappointing Q2 earnings report, analysts still expect Amazon to grow e-commerce sales by 17% in 2022 (Chart 9). Such a goal may be difficult to achieve, given that core US retail sales currently stand 13% above their trendline (Chart 10). Chart 9AAnalysts’ Great Expectations May Be Dashed (I) Chart 9BAnalysts’ Great Expectations May Be Dashed (II) Chart 10AUS Retail Spending Is Well Above Trend (I) Chart 10BUS Retail Spending Is Well Above Trend (II) Chart 11Screen Time Is Moderating If e-commerce spending slows, shares of payment processing companies could disappoint. Likewise, social media companies could suffer as people start going out more often. After spiking during the height of the pandemic, growth in data usage has returned to normal (Chart 11). Long-Term Risks Looking beyond the post-pandemic recovery, all three equity sectors face structural challenges that are not being fully discounted by investors. The first is market saturation. Close to three-quarters of US households have Amazon Prime accounts. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Competition is another challenge. Companies such as Amazon, Facebook, and Google dominate their respective markets. As they look for further growth, they will invariably invade each other’s turf. The result might benefit consumers, but it is unlikely to help the bottom line if it means more competitive pressures. Moreover, it is not just competition from within the tech industry that may disrupt incumbent firms. Consider payment processors. Like most other central banks, the Fed is planning to launch its own digital currency. Widely available, free-to-use Central Bank Digital Currencies (CBDCs) could thwart the ability of Visa and MasterCard to skim 2%-to-3% off of every transaction. Regulatory Pressures In recent years, tech companies have faced increased scrutiny over their alleged monopolistic practices. In contrast to Chinese tech firms, which have fallen under the thumb of the authorities, US companies have been able to evade harsh measures. Just last month, a US federal court judge dismissed a case filed by more than 40 state attorneys general arguing that Facebook’s acquisitions of Instagram and WhatsApp had harmed competition. In the past, evidence that companies were setting prices well above marginal costs could be used to build a case for anti-trust enforcement. Such cases are more difficult to argue today because so many online services are given away for free. Nevertheless, governments are likely to become more adept in pursuing regulatory actions. Rather than focusing simply on pricing policies, regulators are increasingly looking at the ways big tech companies use vendor data in the case of Amazon and user data in the case of Facebook and Google to maintain market dominance. Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted earlier this year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019. The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 1). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies. Table 1American Views On Big Tech A Drug Worse Than Nicotine? Social media companies are among the most loathed within the tech sector. A Pew Research Center study conducted last year revealed that more than six times as many Americans had a negative opinion of social media as a positive one (Chart 12). The public’s disdain for social media is increasingly going beyond traditional concerns over privacy. As psychologists Jonathan Haidt and Jean Twenge recently argued in the New York Times, there is growing evidence that the pervasive use of social media is harming the mental health of the nation’s youth. The share of students reporting high levels of loneliness has more than doubled in both the US and abroad over the past decade (Chart 13). Chart 12Social Media Increasingly Vilified Chart 13Alone In The Crowd In 2019, the last year for which comprehensive data is available, nearly a quarter of girls between the ages of 12 and 17 reported experiencing a major depressive episode over the prior year, up from 12% in 2011 (Chart 14). Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. Facebook and most other social media companies already restrict access to those under the age of 13, although enforcement is generally spotty. We assign a 50/50 chance that governments start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Priced For Perfection The seven companies in the three high-flying sectors mentioned in this report trade at 91-times forward earnings compared to the S&P 500’s aggregate multiple of 22. They also trade at an average price-to-sales ratio of 16 compared to 3.2 for the broader market (Chart 15). Chart 14The Rise In Depression Rates Coincided With Increased Social Media Usage Chart 15Trading At A High Multiple To Sales   Such valuations can be justified only if these companies grow earnings-per-share by nearly 30% per year over the next five years, as analysts currently expect (Chart 16). However, as noted above, that may be too high a hurdle to clear. Higher bond yields represent another threat to valuations. Growth stocks are much more sensitive to changes in discount rates than value stocks. Chart 17show that tech stocks have generally outperformed the S&P 500 over the past four years whenever bond yields were falling. We expect bond yields to rebound over the coming months, with the 10-year yield rising to 1.8% by early next year. Tech is likely to lag the market in that environment. Chart 16Long-Term Growth Estimates May Be Too Optimistic For These High-Fliers Chart 17Higher Bond Yields Could Hurt Tech Stocks   Trade Update Our long EM equity trade got stopped out last Tuesday before recouping some of its losses in subsequent days. We continue to expect EM stocks to bounce back later this year. That said, in keeping with this report, we see more upside for “traditional” EM sectors such as banks, industrials, energy, and materials than for EM tech (especially Chinese tech). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

With two thirds of the S&P 500 companies reported Q2-2021 earnings, it becomes abundantly clear that the US experienced a rigorous economic revival in the second quarter of this year. Combination of loose fiscal and monetary policy, economic reopening, pent up demand and well-to-do US consumer and global growth acceleration are just some of the factors underpinning robust top- and bottom-line growth. Analysts keep revising their forward estimates higher, not lower as earnings season was rolling on – a rather unusual phenomenon (see chart). Zooming into the sector data is also instructive. On the earnings’ front, the Consumer Discretionary and the Financials sectors are leading the market surprise factor higher with 31% and 25% growth respectively. 96% of the technology companies and 95% of the financial companies have beaten the analyst targets, suggesting that expectations were rather low despite the upgrades. In comparison, 78% and 73% of companies beating expectation in the Materials and Energy sectors, look measly. At the same time, Materials are the clear cyclical laggards with a surprise factor of 7%. These results are consistent with our equity investment themes: China slowdown: Underweight Materials as demand for metals is waning Consumers flush with cash: Overweight the Consumer Discretionary sector Rate stabilization: Overweight growth sectors and underweight value (growth sectors, such as Technology and Communications Services are ahead of the value sectors, such as Materials, Energy and Utilities) Economic growth peaking at the end of Q2-2021: Financials outperforming as geared to economic growth acceleration. Bottom Line: With more than 2/3 of S&P 500 reported, the earnings season will likely finish on a high note.

In yesterday’s Sector Insight report we looked at the implications of the termination of the US national eviction ban. However, just as we went to print, the news has hit the tape that the CDC announced a new 60-day eviction moratorium in the areas with high levels of COVID-19 infections. These areas, covered by the eviction ban, account for 80% of the US counties and 90% of the US population. De facto, this moratorium is national, just as the one before.  While there are doubts about the legitimacy of this new law, it will take a while to dispute it in courts. Also, while time will tell if there are extensions of this eviction ban, for now, all the benefits of ending the moratorium that we outlined in the previous report, are on hold.

Last weekend, the national eviction moratorium, put in place during the pandemic, expired. While our hearts go out for the affected families, wearing our economists’ hats, we consider the termination of the eviction ban a likely positive for the US economy, and the US equities. The US is experiencing a red-hot job market with companies struggling to fill positions. End of eviction moratorium may be a necessary catalyst for more workers joining the work force. Indeed, interest in online recruitment postings is picking up (see chart). Ability to fill in open positions will put a lid on the rising wages and contain a vicious cycle of inflation. Investment implication of this development is a further boost to home improvement stocks (HD, LOW) and residential REITS. Evictions will help vulnerable landlords, responsible for real estate taxes, mortgage payments, utilities, and repairs, avoid bankruptcies by finding solvent tenants. Landlords will spend again preparing houses and apartments for a changeover, contributing to the economic growth. Rent prices will increase, in response to ubiquitous housing shortages, and boosting performance of REITs. The likely passage of a bipartisan infrastructure bill and a larger infrastructure-and-social-welfare bill through Congress will expand the social safety net, supporting victims of evictions. Bottom Line: The termination of the national eviction ban is a small net positive for the home improvement and residential REITs equity industries.

Highlights Last week’s market gyrations do not mark the end of China’s structural reforms. The country’s macro policy setting has shifted to allow a higher tolerance for short-term pain in exchange for long-term gain. Chinese policymakers will temporarily put the brakes on its reform agenda if policy measures threaten domestic economic stability; a spillover from the equity market rout to the currency market and private-sector investment will be a pressure point for the authorities. Messages from last week’s Politburo meeting were only marginally more positive than in April. While policymakers seem to be paying more attention to the economic slowdown, they do not appear to be in a rush to rescue the economy. We present three scenarios describing how the equity markets and policy may develop in the coming months. In all the scenarios, investors should avoid trying to catch a falling knife. Feature July was an extraordinarily difficult time for Chinese stocks and last week’s steep slide intensified as a slew of announced regulatory changes spooked market participants (Chart 1). Chart 1Chinese Stocks Had A Tough MonthWe have repeatedly outlined the risks to Chinese equities in the past month. Since the PBoC cut the reserve requirement ratio in early July, the negative impact on the financial markets from tightening industry policies has outweighed the limited positive effects from a slightly more dovish central bank policy stance.  Chart 2Chinese TMT Stock Prices Were Hammered Is now a good time to buy Chinese stocks? Multiple compressions have made Chinese equities, particularly the hard-hit technology, media & telecom (TMT) stocks in the offshore market, appear cheap compared with their global counterparts (Chart 2). In this report we present three scenarios how China’s equity market and policies will likely evolve. In our view, more than a week of stock selloffs will be needed for policymakers to halt reforms. Furthermore, even if the pace of reforms eases and policymakers start to reflate the economy, it will likely take between 6 and 12 months for stock prices to find a bottom.  In light of escalating uncertainty over China’s financial market performance, the China Investment Strategy and Global Asset Allocation services will jointly publish a Special Report on August 18. We will examine how global investors can improve the risk-reward profile of their multi-asset portfolios with exposure to Chinese assets.   Three Scenarios While the regulatory landscape is unclear, we can draw on previous experience to analyze how China’s equity market and policy directions may evolve. In the first scenario, which is our baseline case, the economy would weaken, but would not cross policymakers’ pain threshold. There would be marginal policy easing action to alleviate market anxiety and monetary policy would be slightly loosened along with polices on some non-core sectors, such as infrastructure investment. In this scenario, structural reforms could continue for another 6 to 12 months, as suggested by colleagues at the BCA Geopolitical Strategy services. Investors should resist the urge to buy on the dip. Investors would be kept on edge by a confluence of a slowing economy (even though the slowdown is measured) and heighted regulatory oversight. The market would oscillate between technical rebounds when macro policy eases and selloffs when industry regulations tighten. There are two reasons why the pace of regulatory tightening will not moderate in the near term. First, China’s economic policy has shifted from setting an annual economic growth target to multi-year planning. This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits. Despite a deep dive in stock prices last week, China’s bond and currency markets have been stable relative to the market gyrations in both 2015 and 2018 (Chart 3A and 3B).  Furthermore, the newly released PMIs and recent economic data show that the China’s economic activity is weakening, but the speed of softening seems to be within the policymakers’ comfort zone (Chart 4). Chart 3AChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 3BChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 4Economic Pain Has Not Crossed Policymakers' Threshold Secondly, the new rules imposed on industries - ranging from internet, property, education, healthcare to capital markets - are part of China’s long-term structural reform agenda outlined in the 14th Five-Year Plan (FYP).  As China transitions from building a "moderately prosperous society" by 2020 to becoming a "great modern socialist nation" by 2049, the country’s policy priority has shifted from a rapid accumulation of wealth to addressing income inequality and social welfare for average households.  The policy objective is not only to close regulatory loopholes and end the disorderly expansion of capital and market shares, but also assign a larger weight of social equality and responsibility to the private sector’s business practices. The pace in achieving this overarching goal will only moderate when China’s economy and financial markets show meaningful signs of stress. The second possibility would be if policymakers fail to restore investors’ confidence. Foreign and domestic investors would reassess China’s policy directions and reprice the outlook for corporate profit growth. Market selloffs would continue, like in 2015 and 2018 following policy shocks,1 equity market gyrations would spill over to the currency market through capital outflows and real economic sectors through dwindling investment (Chart 5). In this scenario, Chinese policymakers would likely abandon their reform agenda, at least temporarily, and decisively shift policy to reflate the economy (Chart 6). Chart 5Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Chart 6...Triggering Decisive Reflationary Policy Responses A third scenario would be if China is challenged by the external environment, either due to a significant increase in geopolitical conflicts or a widespread resurgence of new COVID cases. Both aspects would pose sizable downside risks to China’s economic activity. The risks would force authorities to shift to an easier stance and slow the pace of domestic reforms. Chart 7It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out In the second and third scenarios, the rout in the equity market would likely deepen in the near term, before prices bottom in response to a halt in regulatory crackdowns and a decisive turn to reflationary measures. As illustrated in Chart 7, in both 2015 and 2018, it took 6 to 12 months and significant stimulus for Chinese stock prices to bottom in absolute terms. Bottom Line: Our baseline scenario suggests a continuation of structural reforms. Investors should refrain from jumping into the market until there are firm signs that regulatory tightening is over and reflationary measures have started. Key Messages From The Politburo Meeting Last week’s much-anticipated Politburo meeting, chaired by President Xi Jinping, adopted a slightly more dovish tone towards macroeconomic policy than in April, but also indicated that the leadership will stick to its long-term reform agenda. The stance was mildly positive for the overall economy and financial markets. Macro policies in some non-core sectors, such as infrastructure investment, will likely ease at the margin during the rest of the year. However, the meeting’s statement warned “a more complex and challenging external environment” lies ahead, which indicates that heightened concerns over geopolitical tensions will only exacerbate regulatory oversights in data and national security.  Regarding fiscal policy in 2H21, the authorities seem to be growing more concerned about growth outlook.  The meeting mentioned that fiscal support should make “reasonable progress” later this year and early next year. The pace of local government special purpose bond (SPB) issuance will pick up in Q3 and into Q4. However, we maintain our view that without a significant rise in bank credit growth, an acceleration in SPB issuance will only provide a moderate boost to local infrastructure spending. The reference to cross-cycle policy adjustment from the meeting readout is also in line with our view that policymakers may save their fiscal ammunition for next year when the economy comes under greater downward pressure. Odds are rising that the authorities will allow a frontloading of SPBs in Q1 2022 before the National People’s Congress in March next year. The statement also notably mentioned that government officials shall “ensure the supply of commodities and stabilize prices" and called for a more rational pace in carbon reduction. We think this message implies a temporary easing of production curbs in some heavy industries, such as steel, coal, and possibly a further release of strategic reserves of industrial metals (Chart 8A and 8B). The supply-side policy shift should add downward pressure on global industrial prices in addition to the ongoing slowdown in demand from China (Chart 9). Chart 8ASome Backpaddling Likely In Decarbonization Progress Chart 8BSome Backpaddling Likely In Decarbonization Progress Chart 9Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Meanwhile, the meeting repeated the "three stabilization” policy, which targets stabilizing land prices, housing prices and property market expectations. This sends a strong signal that policymakers are unwilling to soften the tone on restrictions in the housing market. Bottom Line: The July Politburo meeting’s messaging was only modestly more dovish than three months ago. Investment Implications Chinese offshore stocks have fallen by 26% from their February peak, compared with approximately 14% for onshore stocks. The offshore TMT stocks are approaching their long-term technical resistance, measured by the three-year moving average in prices (Chart 10). While the magnitude of last week’s stock price decline seems excessive relative to previous market selloffs, the multiple compression reflects considerable uncertainty surrounding the outlook for China’s policy direction. New antitrust regulations in China are intended to limit the monopolistic business practices of internet companies. As a result, these companies’ operational costs will rise and profit growth will decline, and their valuations will converge with those of non-TMT companies. The trailing P/E ratio in Chinese investable TMT stocks is still elevated, making the equities vulnerable to further regulatory tightening and multiple compressions (Chart 11). Chart 10Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chart 11...But Still Vulnerable To Further Multiple Compression     Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1On August 11, 2015, the PBOC surprised the market with three consecutive devaluations of the Chinese yuan, knocking over 3% off its value. On April 3, 2018 former US President Donald Trump unveiled plans for 25% tariffs on about $50 billion of Chinese imports. Market/Sector Recommendations Cyclical Investment Stance