Sectors

Highlights The ongoing transition to a post-pandemic state and fiscal policy are either positive or net-neutral for risky asset prices. Fiscal thrust will turn to fiscal drag over the coming year, but the negative impact this will have on goods spending will likely be offset by a significant improvement in services spending, and thus is not likely to cause a concerning slowdown in overall economic activity. A modestly hawkish shift in the outlook for monetary policy is likely over the coming year, potentially occurring over the late summer or early fall in response to outsized jobs growth. However, such a shift is not likely to become a negative driver for risky asset prices over the coming 6-12 months, barring a major rise in market expectations for the neutral rate of interest. This may very well occur once the Fed begins to raise interest rates, but not likely before. Investors should overweight risky assets within a multi-asset portfolio, and fixed-income investors should maintain a below-benchmark duration position. We continue to favor value over growth on a 6-12 month time horizon, although growth may outperform in the near term. A bias toward value over the coming year supports an overweight stance toward global ex-US equities, and an overall pro-risk stance favors bearish US dollar bets. Feature Three factors continue to drive our global macroeconomic outlook and our cyclical investment recommendations. The first factor is our assessment of the global progress that is being made on the path to a post-pandemic state, and the return to pre-COVID economic conditions; the second is the likely contribution to growth from fiscal policy over the coming year; and the third is the outlook for monetary policy and whether or not monetary conditions will remain stimulative for both economic activity and financial markets. If the world continues to progress meaningfully on the path to a post-pandemic state, and if the impact of fiscal and monetary policy remains in line with market expectations, then we see no reason to alter our recommended investment stance. Equity market returns will be modest over the coming 6 to 12 months in this scenario given how significantly stocks have rebounded from their low last year, but we would still expect stocks to outperform bonds and would generally be pro-cyclically positioned. We present below our assessment of these three factors and their potential to deviate from consensus expectations over the coming year, to determine their likely impact on economic activity and financial markets. The Ongoing Transition To A Post-Pandemic World Chart I-1Enormous Progress Has Been Made In The Fight Against COVID-19 Enormous Progress Has Been Made In The Fight Against COVID-19 Enormous Progress Has Been Made In The Fight Against COVID-19 Chart I-1 highlights that meaningful progress continues to be made in vaccinating the world's population against COVID-19. North America and Europe continue to lead the rest of the world based on the share of people who have received at least one dose, but South America continues to make significant gains, and recent data updates highlight that Asia and Oceania are also making meaningful progress. Africa is the clear laggard in the war against SARS-COV-2 and its variants, but progress there has been delayed, at least in part, by India’s export restrictions of the Oxford-AstraZeneca/COVISHIELD vaccine. This suggests that, while Africa will continue to lag, the share of Africans provided with a first dose of vaccine will begin to rise once India resumes its exports and deliveries to African countries under the COVAX program continue. If variants of the disease were not a source of concern, Chart I-1 would highlight that the full transition to a post-pandemic economy over the next several months would be near certain. However, as evidenced by the recent decision in the UK to postpone the lifting of COVID-19 restrictions by 4 weeks due to the spreading of the Delta variant, the global economy is not entirely out of the woods yet. Encouragingly, the delay in the UK genuinely appears to be temporary. Chart I-2 highlights that while the number of confirmed UK COVID-19 cases has been rising over the past month, the uptick in hospitalizations and fatalities has so far been quite muted. Importantly, the rise in hospitalizations appears to be occurring among those who have not yet been fully vaccinated, underscoring that variants of the disease are only truly concerning if they are vaccine-resistant. The evidence so far is that the Delta variant is more transmissible and may increase the risk of hospitalization, but that two doses of COVID-19 vaccine offer high protection. Of course, vaccines only offer protection if you get them, and evidence of vaccination hesitancy in the US is thus a somewhat worrying sign. Chart I-3 shows that the daily pace of vaccinations in the US has slowed significantly from mid-April levels, resulting in a slower rise in the share of the population that has received at least one dose (second panel). On this metric, the US has recently been outpaced by Canada, and the gap between the UK and the US is now widening. Germany and France are close behind the US and may surpass it soon. Chart I-2The UK Delay In Removing Restrictions Seems Genuinely Temporary The UK Delay In Removing Restrictions Seems Genuinely Temporary The UK Delay In Removing Restrictions Seems Genuinely Temporary Chart I-3Recent Vaccination Progress In The US Has Been Underwhelming Recent Vaccination Progress In The US Has Been Underwhelming Recent Vaccination Progress In The US Has Been Underwhelming   Sadly, Chart I-4 highlights that there is a political dimension to vaccine hesitancy in the US. The chart shows that state by state vaccination rates as a share of the population are strongly predicted by the share of the popular vote for Donald Trump in the 2020 US presidential election. Admittedly, part of this relationship may also be capturing an urban/rural divide, with residents in less-dense rural areas (which typically support Republican presidential candidates) perhaps feeling a lower sense of urgency to become vaccinated against the disease. Chart I-4The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants July 2021 July 2021 But given the clear politicization that has already occurred over some pandemic control measures, such as the wearing of masks, Chart I-4 makes it difficult to avoid the conclusion that the same thing has occurred for vaccines. This is unfortunate, and seemingly raises the risk that the Delta variant may spread widely in red states over the coming several months, potentially delaying economic reopening, or risking the reintroduction of pandemic control measures. However, there are two counterarguments to this concern. First, non-vaccine immunity is probably higher in red than blue states, and CDC data suggest that this effect could be large. While this figure is still preliminary and subject to change (and likely will), the CDC estimates that only 1 out of 4.3 cases of COVID-19 were reported from February 2020 to March 2021. Taken at face value, this implies that there were approximately 115 million infections during that period, compared with under 30 million reported cases. That gap accounts for 25% of the US population, and given that red states were slower to implement pandemic control measures last year and their residents often more resistant to the measures, it stands to reason that a disproportionate share of unreported cases occurred in these states. Second, as noted above, the evidence thus far suggests that the Delta variant is not vaccine resistant, at least for those who are fully vaccinated. This is significant because if Delta were to spread widely in red states over the coming several months, the resulting increase in hospitalizations would likely convince many vaccine hesitant Americans to become vaccinated out of fear and self-interest – two powerfully motivating factors. Thus, the Delta variant may become a problem for the US in the fall, but if that occurs a solution is not far from sight. And, in other developed countries where vaccine hesitancy rates appear to be lower, it would seem that a new, vaccine-resistant variant of the disease would likely be required in order to cause a major disruption in the transition to a post-pandemic state. Such a variant could emerge, but we have seen no evidence thus far that one will before vaccination rates reach levels that would slash the odds of further widespread mutation. Fiscal Policy: Passing The Baton To Services Spending Chart I-5 highlights that US fiscal policy is set to detract from growth over the coming 6-12 months, reflecting the one-off nature of some of the fiscal response to the pandemic. This is true outside of the US as well, as Chart I-6 highlights that the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, representing a significant amount of fiscal drag relative to the past two decades. Chart I-5Fiscal Thrust Will Eventually Turn To Fiscal Drag In The US… July 2021 July 2021 Should investors be concerned about the impact of fiscal drag on advanced economies over the coming year? In our view, the answer is no. The reason is that much of the fiscal response in the US and Europe has been aimed at supporting income that has been lost due to a drastic reduction in services spending, which will continue to recover over the coming months as the effect of the pandemic continues to ebb. Chart I-7 underscores this point by highlighting the “gap” in US consumer goods and services spending relative to its pre-pandemic trend. The chart highlights that US goods spending is running well above what would be expected, whereas there is a sizeable gap in services spending (which accounts for approximately 70% of US personal consumption expenditures). Goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the sizeable amount of excess savings that US households have accumulated over the past year (Chart I-7, panel 2). Chart I-6... And In Europe ... And In Europe ... And In Europe Chart I-7But Reduced Transfers Will Only Impact Spending On Goods, Not Services But Reduced Transfers Will Only Impact Spending On Goods, Not Services But Reduced Transfers Will Only Impact Spending On Goods, Not Services While some of these savings have already been deployed to pay down debt and some may be permanently saved in anticipation of higher future taxes, the key point for investors is that the negative impact on goods spending from reduced fiscal thrust will be offset by a significant improvement in services spending, and thus is not likely to cause a concerning slowdown in overall economic activity. Monetary Policy: A Modestly Hawkish Shift Is Likely This leaves us with the question of whether or not monetary policy will become a negative driver for risky asset prices over the coming 6-12 months, which is especially relevant following last week’s FOMC meeting. The updated “dot plot” following the meeting shows that 7 of the 18 FOMC participants anticipate a rate hike in 2022, and the majority (13 members) expect at least one rate hike before the end of 2023, raising the median forecast for the Fed funds rate to 0.6% by the end of that year. Chart I-8 highlights that while 10-year Treasury yields remains mostly unchanged following the meeting, yields moved higher at the short-end and middle of the curve. Chart I-8The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields The FOMC Meeting Resulted In Higher Short- And Mid-Term Yields Investor fears that the Fed may shift in a significantly hawkish direction at some point over the next year have been far too focused on inflation, and far too little focused on employment. It is not a coincidence that the Fed’s guidance was updated following the May jobs report, which saw a stronger pace of jobs growth relative to April. Table I-1 updates our US Bond Strategy service’s calculations showing the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 3.5-4.5% assuming a full recovery in the participation rate, which is the range of the Fed’s NAIRU estimates. May’s payroll growth number of 560k implies that the Fed’s maximum employment criterion will be met sometime between June and September next year, if monthly payroll growth continues at that pace. Table I-1Calculating The Distance To Maximum Employment July 2021 July 2021 Chart I-9Lighter Restrictions In Blue States Will Push Down The Unemployment Rate Lighter Restrictions In Blue States Will Push Down The Unemployment Rate Lighter Restrictions In Blue States Will Push Down The Unemployment Rate It is currently difficult to assess with great confidence what average payroll growth will prevail over the coming year, but we noted in last month’s report that there were compelling arguments in favor of outsized jobs growth this fall.1 In addition to those points, we note the following: Blue states have generally been slower to reopen their economies, and Chart I-9 highlights that these states have consequently been slower to return to their pre-pandemic unemployment rate. Among blue states, California and New York are the largest by population, and it is notable that both states only lifted most COVID-19 restrictions on June 15 – including the wearing of masks in most settings. This implies that services jobs are likely to grow significantly in these states over the coming few months. Both consensus private forecasts as well as the Fed’s expectation for real GDP growth imply that the output gap will be closed by Q4 of this year (Chart I-10). These expectations appear to be reasonable, given the substantial amount of excess savings that have been accumulated by US households and the fact that monetary policy remains extremely stimulative. When the output gap turned positive during the last economic cycle, the unemployment rate was approximately 4% – well within the Fed’s NAIRU range. Chart I-10 also shows that the Fed’s 7% real GDP growth forecast for this year would put the output gap above its pre-pandemic level, when the unemployment rate stood at 3.5%. In fact, it is possible that annualized Q2 real GDP growth will disappoint current consensus expectations of 10%, due to the scarcity of labor supply (scarcity that will be eased by labor day when supplemental unemployment insurance benefit programs end). Were Q2 GDP to disappoint due to supply-side limitations, it would strengthen the view that job gains will be very strong this fall ceteris paribus, as it would highlight that real output per worker cannot rise meaningfully further in the short-term and that stronger growth later in the year will necessitate very large job gains. Chart I-11 highlights that US air travel and New York City subway ridership have already returned close to 75% and 50% of their pre-pandemic levels, respectively. Based on the trend over the past three months, the chart implies that air travel will return to its pre-pandemic levels by mid-October of this year, and New York City subway ridership by June 2022. This underscores that travel-related services employment will recover significantly in the fall, and that jobs in downtown cores will rebound as office workers progressively return to work. Chart I-10Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Expectations For Growth This Year Suggest A Rapid Decline In The Unemployment Rate Chart I-11Services Employment Will Recover In The Fall Services Employment Will Recover In The Fall Services Employment Will Recover In The Fall   On the latter point, one major outstanding question affecting the outlook for monetary policy is the magnitude of the likely permanent impact of work from home policies on employment in central business districts. Fewer office workers commuting to downtown office locations suggests that some jobs in the leisure & hospitality, retail trade, professional & business services, and other services industries will never return or will be very slow to do so, arguing for a longer return to maximum employment (and the Fed’s liftoff date). We examine this question in depth in Section 2 of this month’s report, and find that the “stickiness” of work from home policies will likely cause permanent central business job losses on the order of 575k (or 0.35% of the February 2020 labor force). While this would be non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Outsized jobs growth this fall, at a pace that quickly reduces the unemployment rate, argues for a first Fed rate hike that is even earlier than the market expects. Chart I-12 presents The Bank Credit Analyst service’s current assessment of the cumulative odds of the Fed’s liftoff date by quarter; we believe that it is likely that the Fed will have raised rates by Q3 of next year, and that a rate hike in the first half of 2022 is a possibility. These odds are slightly more aggressive than those presented by our fixed-income strategists in a recent Special Report,2 but are consistent with their view that the Fed will raise interest rates by the end of next year. Chart I-12The Bank Credit Analyst’s Assessment Of The Odds Of The First Rate Hike July 2021 July 2021 The odds presented in Chart I-12 are also more hawkish than the Fed funds rate path currently implied by the OIS curve, meaning that we expect investors to be somewhat surprised by a shifting monetary policy outlook at some point over the coming year, potentially over the next 3-6 months. Payroll growth during the late summer and early fall will be a major test for the employment outlook, and is the most likely point for a hawkish shift in the market’s view of monetary policy. Is this likely to become a negative driver for risky asset prices over the coming 6-12 months? In our view, the answer is “probably not.” While investors tend to focus heavily on the timing of the first rate hike as monetary policy begins to tighten, the reality is that it is the least relevant factor driving the fair value of 10-year Treasury yields. Investor expectations for the pace of tightening and especially for the terminal Fed funds rate are far more important, and, while it is quite possible that expectations for the neutral rate of interest will eventually rise, it seems unlikely that this will occur before the Fed actually begins to raise interest rates given that most investors accept the secular stagnation narrative and the view that “R-star” is well below trend rates of growth (we disagree).3 Chart I-13 highlights the fair value path of 10-year Treasury yields until the end of next year, assuming a 2.5% terminal Fed funds rate, no term premium, and a rate hike pace of 1% per year. The chart highlights that while government bond yields are set to move higher over the coming 6-12 months, they are likely to remain between 2-2.5%. This would drop the equity risk premium to a post-2008 low (Chart I-14), which would further reduce the attractiveness of stocks relative to bonds. But we doubt that this would be enough of a decline to cause a selloff, and it would still imply a stimulative level of interest rates for households and firms. Chart I-1310-Year Yields Will Rise Over The Coming Year, But Not Sharply 10-Year Yields Will Rise Over The Coming Year, But Not Sharply 10-Year Yields Will Rise Over The Coming Year, But Not Sharply Chart I-14Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP Rising Yields Will Cause An Unwelcome But Contained Decline In The ERP   Investment Conclusions Among the three factors driving our global macroeconomic outlook and our cyclical investment recommendations, continued progress on the path toward a post-pandemic state and fiscal policy remain either positive or mostly neutral for risky assets. A potentially hawkish shift in the outlook for monetary policy this fall remains the chief risk, but we expect the rise in bond yields over the coming year to remain well-contained barring a sea change in investor expectations for the terminal Fed funds rate – which we believe is unlikely to occur before the Fed begins to raise interest rates. Consequently, we continue to recommend that investors should overweight risky assets within a multi-asset portfolio, and that fixed-income investors should maintain a below-benchmark duration position. We expect modest absolute returns from global equities, but even mid-single digit returns are likely to beat those from long-dated government bonds and cash positions. While value stocks may underperform growth stocks over the coming 3-4 months,4 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector (and therefore growth stock) valuations (Chart I-15). Chart I-16 highlights that the attractiveness of US value versus growth is meaningfully less compelling for the S&P 500 Citigroup indexes, suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon.5 Chart I-15Value Is Extremely Cheap Value Is Extremely Cheap Value Is Extremely Cheap Chart I-16Value Vs. Growth: The Benchmark Matters Value Vs. Growth: The Benchmark Matters Value Vs. Growth: The Benchmark Matters   The likely outperformance of value versus growth also has implications for regional allocation within a global equity portfolio. The US is significantly overweight broadly-defined technology relative to global ex-US stocks, and financials – which are overrepresented in value indexes – have already meaningfully outperformed in the US this year compared with their global peers and are now rolling over (Chart I-17). This underscores that investors should favor ex-US stocks over the coming year, skewed in favor of DM ex-US given that China’s credit impulse continues to slow (Chart I-18). Chart I-17Favor Global Ex-US Stocks Over The Coming Year Favor Global Ex-US Stocks Over The Coming Year Favor Global Ex-US Stocks Over The Coming Year Chart I-18Concentrate Global Ex-US Exposure In Developed Markets Concentrate Global Ex-US Exposure In Developed Markets Concentrate Global Ex-US Exposure In Developed Markets   Finally, global ex-US stocks also tend to outperform when the US dollar is falling, and we would recommend that investors maintain a short dollar position on a 6-12 month time horizon despite the recent bounce in the greenback. Chart I-19 highlights that the dollar remains strongly negatively correlated with global equity returns, and that the dollar’s performance over the past year has been almost exactly in line with what one would have expected given this relationship. Thus, a bullish view toward global stocks implies both US dollar weakness and global ex-US outperformance over the coming year. Chart I-19A Bullish View Towards Global Stocks Implies A Dollar Bear Market A Bullish View Towards Global Stocks Implies A Dollar Bear Market A Bullish View Towards Global Stocks Implies A Dollar Bear Market Jonathan LaBerge, CFA Vice President The Bank Credit Analyst June 24, 2021 Next Report: July 29, 2021   II. Work From Home “Stickiness” And The Outlook For Monetary Policy Work from home policies, originally designed as emergency measures in the early phase of the COVID-19 pandemic, are likely to be “sticky” in a post-pandemic world. This will negatively impact the labor market in central business districts, via reduced spending on services by office workers. The potential impact of working from home is often cited as an example of what is likely to be a lasting and negative effect on jobs growth, but we find that it is not likely to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment.” The size of the impact depends importantly on whether employee preferences or employer plans for WFH prevail, but our sense is that the latter is more likely. A weaker pace of structures investment in response to elevated office vacancy rates will likely have an even smaller impact on growth than the effect of reduced central business district services employment. The contribution to growth from structures investment has been small over the past few decades, office building construction is a small portion of overall nonresidential structures, and there are compelling arguments that the net stock of office structures will stay flat, rather than decline. Our analysis suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months. The outlook for US monetary policy over the next 12 to 18 months depends almost entirely on the outlook for employment. Many investors are focused on the potential for elevated inflation to force the Fed to raise interest rates earlier than it currently anticipates, but it is the progress in returning to “maximum employment” that will determine the timing of the first Fed rate hike – and potentially the speed at which interest rates rise once policy begins to tighten. In this report, we estimate the extent to which the “stickiness” of working from home (WFH) policies and practices could leave a lasting negative impact on the US labor market. We noted in last month's report that a large portion of the employment gap relative to pre-pandemic levels can be traced to the leisure & hospitality and professional and business services industries, both of which – along with retail employment – stand to be permanently impaired if the office worker footprint is much lower in a post-COVID world.6 Using employee surveys and a Monte Carlo approach, we present a range of estimates for the permanent impact of WFH policies on the unemployment rate, and separately examine the potential for lower construction of office properties to weigh on growth. We find that the impact of reduced office building construction is likely to be minimal, and that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. Relative to the Fed’s expectations of a strong, lasting impact on the labor market from the pandemic, this suggests that job growth over the coming year could be even stronger than the Fed and investors expect, possibly resulting in a first rate hike by the middle of next year. This would be earlier than we currently anticipate, but it underscores that fixed-income investors should remain short duration on a 6-12 month time horizon, and that equity investors should favor value over growth positions beyond the coming 3-4 months (a period that may see outperformance of the latter). Quantifying The Labor Market Impact Of The New Normal For Work In a January paper, Barrero, Bloom, and Davis (“BBD”) presented evidence arguing why working from home will “stick.” The authors surveyed 22,500 working-age Americans across several survey “waves” between May and December 2020, and asked about both their preferences and their employer’s plans about working from home after the pandemic. Chart II-1 highlights that the desired amount of paid work from home days (among workers who can work from home) reported by the survey respondents is to approximately 55% of a work week, suggesting that a dramatic reduction in office presence would likely occur if post-pandemic WFH policies were set fully in accordance with worker preferences. Chart II-1Employee Preferences Imply A Dramatic Reduction In Post-COVID Office Presence July 2021 July 2021 However, Table II-1 highlights that employer plans for work from home policies are meaningfully different than those of employees. The table highlights that employers plan for employees to work from home for roughly 22% of paid days post-pandemic, which essentially translates to one day per week on average.7 BBD noted that CEOs and managers have cited the need to support innovation, employee motivation, and company culture as reasons for employees’ physical presence. Managers believe physical interactions are important for these reasons, but employees need only be on premises for about three to four days a week to achieve this. Table II-1 also shows that employers plan to allow higher-income employees more flexibility in terms of working from home, and less flexibility to employees whose earnings are between $20-50k per year. Table II-1Employer Plans, However, Imply Less Working From Home Than Employees Prefer July 2021 July 2021 Based on the survey results, BBD forecast that expenditure in major cities such as Manhattan and San Francisco will fall on the order of 5 to 10%. In order to understand the national labor market impact of work from home policies and what implications this may have on monetary policy, we scale up BBD’s calculations using a Monte Carlo approach that incorporates estimate ranges for several factors: The percent of paid days now working from home for office workers The amount of money spent per week by office workers in central business districts (“CBDs”) The number of total jobs in CBDs The percent of CBD jobs in industries likely to be negatively impacted by reduced office worker expenditure The average weekly earnings of affected CBD workers The average share of business revenue not attributable to strictly variable expenses The percent of affected jobs likely to be recovered outside of CBDs Our approach is as follows. First, we calculate the likely reduction in nationwide CBD spending from reduced office worker presence by multiplying the likely percent of paid days now permanently working from home by the number of total jobs in CBDs and the average weekly spending of office workers. This figure is then increased due to the estimated acceleration in net move outs from principal urban centers in 2020 (Chart II-2); we assume a 5% savings rate and an average annual salary of $50k for these resident workers, and assume that all of their spending occurred within CBDs. We also assume that roughly 50% of jobs connected to this spending are recovered. Chart II-2Fewer Residents Will Also Lower Spending In Central Business Districts July 2021 July 2021 Then, we calculate the gross number of jobs lost in leisure & hospitality, retail trade, and other services by multiplying this estimate of lost spending by an estimate of non-variable costs as a share of revenue for affected industries, and dividing the result by average weekly earnings of affected employees. For affected CBD employees in the administrative and waste services industry, we simply assume that the share of jobs lost matches the percent of paid days now permanently working from home. Finally, we adjust the number of jobs lost by multiplying by 1 minus an assumed “recovery” rate, given that some of the reduction in spending in CBDs will simply be shifted to areas near remote workers’ residences. We assume a slightly lower recovery rate for lost jobs in the administrative and waste services industry. Table II-2 highlights the range of outcomes for each variable used in our simulation, and Charts II-3 and II-4 present the results. The charts highlight that the distribution of outcomes based on employer WFH intensions suggest high odds that nationwide job losses in CBDs due to reduced office worker presence will not exceed 400k. Based on average employee preferences, that number rises to roughly 800-900k. Table II-2The Factors Affecting Permanent Central Business District Job Losses July 2021 July 2021 Chart II-3The Probability Distribution Of CBD Jobs Lost… July 2021 July 2021 Chart II-4…Based On Our Monte Carlo Approach July 2021 July 2021   This raises the question of whether employer plans or employee preferences for WFH arrangements will prevail. Our sense is that it will be closer to the former, given that we noted above that employer WFH plans are the least flexible for employees whose earnings are between $20-50k per year (who are presumably employees who have less ability to influence the policy of firms). Chart II-5 re-presents the projected job losses shown in Chart II-4 as a share of the February 2020 labor force, along with a probability-weighted path that assumes a 75% chance that employer WFH plans will prevail. The chart highlights that WFH arrangements would have the effect of raising the unemployment rate by approximately 0.35%. However, relative to a pre-pandemic starting point of 3.5%, this would raise the unemployment rate to a level that would still be within the Fed’s NAIRU estimates (Chart II-6). Therefore, the “stickiness” of WFH arrangements alone do not seem to be a barrier to the labor market returning to the Fed’s assessment of “maximum employment,” suggesting that the conditions for liftoff may be met earlier than currently anticipated by investors. Chart II-5CBD Job Losses Will Not Be Trivial, But They Will Not Be Enormous July 2021 July 2021 Chart II-6Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment Sticky WFH Policies Will Not Prevent A Return To Maximum Employment The Impact Of Lower Office Building Construction A permanently reduced office footprint could also conceivably impact the US economy through reduced nonresidential structures investment, as builders of commercial real estate cease to construct new office towers in response to expectations of a long-lasting glut. However, several points highlight that the negative impact on growth from US office tower construction will be even smaller than the CBD employment impact of reduced office worker presence that we noted above. First, Chart II-7 highlights the overall muted impact that nonresidential building investment has had on real GDP growth by removing the contribution to growth from nonresidential structures and for overall nonresidential investment. The chart clearly highlights that the historically positive contribution to real US output from capital expenditures over the past four decades has come from investment in equipment and intellectual property products, not from structures. Chart II-8 echoes this point, by highlighting that US real investment in nonresidential structures has in fact been flat since the early-1980s, contributing positively and negatively to growth only on a cyclical basis (not on a structural basis). Chart II-7Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Structures Have Not Contributed Significantly To US Growth For Some Time Chart II-8Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Nonresidential Structures Investment Has Been Flat For Four Decades Second, Table II-3 highlights that office properties make up a small portion of investment in private nonresidential structures. In 2019, nominal investment in office structures amounted to $85 billion, compared with $630 billion in overall structures investment, meaning that office properties amounted to just 13% of structures investment. Table II-3Office Structures Investment Is A Small Share Of Total Structures Investment July 2021 July 2021 Table II-4Conceivably, Vacant Office Properties Could Be Converted To Luxury Residential Units July 2021 July 2021 Third, it is true that investment is a flow and not a stock variable, meaning that, if the net stock of office buildings were to fall as a result from WFH policies, then the US economy would see a potentially persistently negative rate of growth from nonresidential structures (which would constitute a drag on growth). But if the net stock were instead to remain flat, then gross office property investment should equal the depreciation of those structures. The second column of Table II-3 highlights that current-cost depreciation of office structures was $53 billion in 2019 (versus nominal gross investment of $85 billion). Had office property investment been ~$30 billion lower in 2019, it would have reduced nominal GDP by a mere 14 basis points (resulting in an annual growth rate of 3.84%, rather than 3.98%). Fourth, there is good reason to believe that the net stock of office properties will stay flat, as the economics of converting offices to luxury housing units (whose demand is not substantially affected by factors such as commuting) – either fully or partially into mixed-use buildings – appear to be plausible. Table II-4 highlights that the average annual asking rent for office space per square foot in Manhattan was $73.23 in Q1 2021, and that the recent median listing home price per square foot is roughly $1,400. In a frictionless world where office space could be instantly and effortlessly sold as residential property, existing prices would imply a healthy (gross) rental yield of 5.2%. Thoughts On The Future Of Office Properties Of course, reality is far from frictionless. There are several barriers that will slow office-to-residential conversion as well as construction costs, which will meaningfully lower the net value of existing office real estate in large central business districts such as Manhattan. In a recent article in the Washington Post, Roger K. Lewis, retired architect and Professor Emeritus of Architecture at the University of Maryland, College Park, detailed several of these technical barriers (which we summarize below).8 Office buildings are typically much wider than residential buildings, the latter usually being 60 to 65 feet in width in order to enable windows and natural light in living/dining rooms and bedrooms. This suggests that office-to-residential conversion might require modifying the basic structure of office buildings, including cutting open parts of roof and floor plates on upper building levels to bring natural light into habitable and interior rooms, and other costly structural modifications to address the additional plumbing and infrastructure that will be needed. Lewis noted that floor-to-floor dimensions are typically larger in office buildings, which is beneficial for office-to-residential conversion because increased room heights augments the sense of space and openness, while allowing natural light to penetrate farther into the apartment. It also allows for extra space to place needed additional building infrastructure, such as sprinkler pipes, electrical conduits, light fixtures, and air ducts. But unique apartment layouts are often needed to use available floor space effectively in an office-to-residential conversion, which will increase design costs and raise the risk that nonstandard layouts may result in unforeseen quality-of-living problems that will necessitate additional future construction to correct. Zoning regulations and building code constraints will likely add another layer of costs to office-to-housing conversions, as these rules are written for conventional buildings, meaning that special exceptions or even regulatory changes are likely to be required. So it is clear that the process of converting office space to residential property will be a costly endeavor for office tower owners, which will likely reduce the net present value of these properties relative to pre-pandemic levels. But; this process appears to be feasible and, when faced with the alternative of persistently high vacancy rates and lost revenue, our sense is that office tower owners will choose this route – thus significantly reducing the likelihood that the growth in national gross investment in office properties will fall below the rate of depreciation. In addition, the trend in suburban and CBD office property prices suggests that there are two other possible alternatives to widespread office-to-residential conversion that would also argue against a significant and long-lasting decline in office structures investment. Chart II-9 highlights that the average asking rent has already fallen significantly in most Manhattan submarkets, and Chart II-10 highlights that suburban office prices are accelerating and rising at the strongest pace relative to CBD office prices over the past two decades, possibly in response to increased demand for workspace that is closer to home for many workers who previously commuted to CBDs. Chart II-9Working From The Office Is Getting Cheaper July 2021 July 2021 Chart II-10Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Suburban Offices Are Getting More Expensive Thus, the first alternative outcome to CBD office-to-residential conversion is that an increase in suburban office construction offsets the negative impact of outright reductions in CBD office investment if residential conversions prove to be too costly or too technically challenging. The second alternative is that owners of CBD office properties “clear the market” by dramatically cutting rental rates even further, to alter the cost/benefit calculation for firms planning permissive WFH policies. We doubt that existing rents reflect the extent of vacancies in large cities such as Manhattan, so we would expect further CBD office price declines in this scenario. But if owners of centrally-located office properties face significant conversion costs and a decline in the net present value of these buildings is unavoidable and its magnitude uncertain, owners may choose to cut prices drastically as the simpler solution. Investment Conclusions Holding all else equal, the fact that owners of CBD office properties are likely to experience some permanent decline in the value of these real estate assets is not a positive development for economic activity. But these losses will be experienced by firms, investors, and ultra-high net worth individuals with strong marginal propensities to save, suggesting that the economic impact from this shock will be minimal. And as we highlighted above, a decline in the pace of gross office building investment to the depreciation rate will have a minimal impact on the overall economy. This leaves the likely impact on CBD employment as the main channel by which WFH policies are likely to affect monetary policy. As we noted above and as discussed in Section 1 of our report, the Fed is now focused entirely on the return of the labor market to maximum employment, which we interpret as an unemployment rate within the range of the Fed’s NAIRU estimates (3.5% - 4.5%) and a return to a pre-pandemic labor force participation rate. Chart II-11On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth On A One-Year Time Horizon, Favor Value Over Growth Our analysis indicates that WFH policies may structurally raise the unemployment rate by 0.3 to 0.4%. While non-trivial, when compared with a pre-pandemic unemployment rate of 3.5%, this suggests that WFH policies alone are not likely to cause a long-term deviation from the Fed’s maximum employment objective. The implication is that job growth over the coming year could be even stronger than the Fed and investors expect, which could mean that the Fed may begin lifting rates by the middle of next year barring a major disruption in the ongoing transition to a post-pandemic world. This is earlier than we currently expect, but the fact that it would also be earlier than what is currently priced into the OIS curve underscores that fixed-income investors should remain short duration on a 6-12 month time horizon. In addition, as noted in Section 1 of our report, while value stocks may underperform growth stocks over the coming 3-4 months,9 rising bond yields over the coming year will ultimately favor value stocks and will likely weigh on elevated tech sector valuations. Chart II-11 highlights that the relative valuation of growth stocks remains above its pre-pandemic starting point (Chart II-11), suggesting that investors should continue to favor MSCI-benchmarked value over growth positions over a 6-12 month time horizon. Finally, as also noted in Section 1 of our report, we do not expect rising bond yields to prevent stock prices from grinding higher over the coming year, unless investor expectations for the terminal fed funds rate move sharply higher – an event that seems unlikely, although not impossible, before monetary policy actually begins to tighten. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields since last August. The indicator still remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have risen to their highest levels on record. Within a global equity portfolio, there has been a modest tick down in global ex-US equity performance, driven by a rally in growth stocks (which may persist for a few months). EM stocks had previously dragged down global ex-US performance, and they continue to languish. A bias towards value stocks on a 1-year time horizon means that investors should still favor ex-US stocks over the coming year, skewed in favor of DM ex-US given that China’s credit impulse continues to slow. The US 10-Year Treasury yield has trended modestly lower since mid-March, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and we expect that yields will move higher over the cyclical investment horizon if employment growth in Q3/Q4 implies a faster return to maximum employment than currently projected by the Fed. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a short duration stance within a fixed-income portfolio. The extreme rise in some commodity prices over the past several months is beginning to ease. Lumber prices have fallen close to 50% from their recent high, whereas industrial metals and agricultural prices are down roughly 5% and 17%, respectively. We had previously argued that a breather in commodity prices was likely at some point over the coming several months, and we would expect further declines as supply chains normalize, labor supply recovers, and Chinese demand for metals slows. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report "A Central Bank Timeline For The Next Two Years," dated June 1, 2021, available at usbs.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com 5 For a discussion of the differences in value and growth benchmarks, please see Global Asset Allocation Special Report “Value? Growth? It Really Depends!” dated September 19, 2019, available at gaa.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2021," dated May 27, 2021, available at bca.bcaresearch.com 7 Readers should note that the desired share of paid work from home days post-COVID among employees is shown to be lower in Table II-1 than what is implied by Chart II-1 on a weighted-average basis. This is due to the fact that Table II-1 excludes responses from the May 2020 survey wave, because the authors did not ask about employer intensions during that wave. This underscores that the average desired number of paid days working from home declined somewhat over time, and thus argues for the value shown in Table II-1 as the best estimate for employee preferences. 8 Roger K. Lewis, “Following pandemic, converting office buildings into housing may become new ‘normal,’ Washington Post, April 3, 2021. 9 Please see US Equity Strategy "Rotate Into Growth Stocks, Be Granular In The Selection Of Cyclicals," dated June 14, 2021, available at uses.bcaresearch.com

Highlights The sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity demand and prices through the remainder of 2021. Commodity demand shocks dominate commodity supply shocks. Commodity supply shocks play only a transient role in setting prices. Go underweight basic resources equities versus the market. Commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar. Fractal trade: Short corn versus wheat. Feature Chart of the WeekDeclining Chinese Lending Is A Headwind For Metal Prices Declining Chinese Lending Is A Headwind For Metal Prices Declining Chinese Lending Is A Headwind For Metal Prices The recent collapse in China’s credit impulse has caught a lot of people’s attention, ours included. The collapse in the credit impulse quantifies the change in lending. Importantly, this means that even if the lending numbers themselves are large, the impulse will collapse if those lending numbers are declining – which is precisely what has happened in China. In the past year, China’s broad money supply has expanded by $17 trillion yuan, signifying a large amount of lending in the $100 trillion yuan economy. All well and good, except that the $17 trillion yuan has declined from an even larger $21 trillion yuan a year ago. To the extent that loans fund the demand for something, the $4 trillion yuan decline in those loans means that the demand for the something also declines. In the case of China, the something is the demand for industrial commodities, especially industrial metals (Chart of the Week). Using total social financing rather than the broad money supply reveals a similar downtrend in lending, and therefore a similarly collapsed impulse (Chart I-2 and Chart I-3) But as we explain in the next section, our preference is to focus on China’s broad money supply. Chart I-2Chinese Lending Is ##br##Declining... Chinese Lending Is Declining... Chinese Lending Is Declining... Chart I-3...So The 12-Month Credit Impulse Has Collapsed ...So The 12-Month Credit Impulse Has Collapsed ...So The 12-Month Credit Impulse Has Collapsed   Declining Chinese Lending Is A Headwind For Metal Demand When interpreting the lending numbers in any economy, there are four important things to keep in mind. First, we should focus on bank lending. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody’s spending power goes down. In contrast, when somebody borrows by issuing a bond, it just reallocates spending power from one person to another. The bond issuer sees his bank account and spending power go up, but the bond buyer sees his bank account and spending power go symmetrically down. Demand will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, and as already mentioned, the impact on economic demand comes from the change in lending – which is to say the credit impulse. This is just to compare apples with apples. Remember that GDP, demand, and lending are all flow statistics. Meaning that the change in demand depends on the change in lending (and not from absolute lending itself).1  Third, the most important part of lending is bank lending to the non-financial sector.2  This is because not all loans generate economic activity. Bank-to-bank lending and reserves held at the central bank stay trapped in the financial system. The money supply – which is on the liabilities side of the banks’ balance sheet – might not pick up this distinction. It could be expanding rapidly due to a surge in bank-to-bank lending and/or in reserves, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending – which is on the assets side of the banks’ balance sheet – and only count lending that is likely to generate economic activity. However, this logic only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. Total social financing includes most, but not all, shadow lending. Yet all shadow lending must eventually show up in the money supply. For this reason, in analysing Chinese lending, we prefer to focus on the broad money supply. Having said that, the messages coming from both the broad money supply and total social financing concur. Chinese lending is slowing. Chinese lending is slowing.  Fourth, we should choose the periodicity of the analysis to maximize its predictive power. This will depend on the specific lead times between the lending and the demand that it is funding, which will be discovered empirically. We find that the 1-year change in China’s broad money supply provides an excellent 1-year lead on industrial metal prices, because the lending leads commodity demand. The obvious rejoinder is, what about tight supply? The answer, from a recent academic paper – Drivers of commodity price booms and busts in the long run – is that for (non-oil) commodities, demand dominates supply. Specifically, “aggregate commodity and commodity-specific demand shocks appear to strongly dominate commodity supply shocks in driving variation in real commodity prices… commodity supply shocks play a rather secondary and transient role.”3 On this basis, we conclude that the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021 (Chart I-4 and Chart I-5). Chart I-4Declining Chinese Lending Is A Headwind For Industrial Metals... Declining Chinese Lending Is A Headwind For Industrial Metals... Declining Chinese Lending Is A Headwind For Industrial Metals... Chart I-5...And Iron Ore ##br##Prices ...And Iron Ore Prices ...And Iron Ore Prices   Chinese Lending Is An Investment ‘Super-Driver’ We are strong believers in investment reductionism. Our reductionist philosophy stems from two guiding principles: Occam’s Razor – which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle – which says that 80% of effects come from just 20% of causes.4 Investment banks hate investment reductionism. Given that they want to sell you as much product as possible, they make investment seem much more complicated than it is. Yet most of the moves in most financial markets result from a very small number of ‘super-drivers.’ Our objective is to un-complicate investment – to identify the super-drivers, and to call them right. Clearly, one super-driver right now is the evolution of the pandemic, and specifically the evolution of new variants of the virus, as we discussed in Viral Variants Strike Down The Reflation Trade. A second super-driver is the direction of the T-bond yield, because this drives the direction of many other market trends such as growth versus value, defensives versus cyclicals, and US versus Europe. As we discussed in Don’t Panic About US Inflation, the T-bond yield is likely to drift lower in the coming months. Today’s report identifies a third super-driver – the evolution of Chinese lending. To repeat, the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021.   The sharp drop in Chinese lending over the past year is highly likely to weigh on commodity prices through the remainder of 2021. This means that basic resources equities are likely to underperform both in absolute terms, and relative to the broader market (Chart I-6 and Chart I-7). On a 6-month horizon, go underweight basic resources versus the market. Chart I-6Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Chart I-7...And Relative To The Broad ##br##Market ...And Relative To The Broad Market ...And Relative To The Broad Market It also means that commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar (Chart I-8 and Chart I-9). Chart I-8The Canadian Dollar Just Tracks Inflation Expectations The Canadian Dollar Just Tracks Inflation Expectations The Canadian Dollar Just Tracks Inflation Expectations Chart I-9The New Zealand Dollar Just Tracks Inflation Expectations The New Zealand Dollar Just Tracks Inflation Expectations The New Zealand Dollar Just Tracks Inflation Expectations Commodities Are Fractally Fragile Reinforcing the super-driver of a Chinese lending slowdown, the 260-day fractal structure of the commodity complex is at the same extreme of fragility that heralded turning-points in 2009, 2010, 2018, and 2020 (Chart I-10). Chart I-10The Fractal Structure Of The Commodity Complex Is Extremely Fragile The Fractal Structure Of The Commodity Complex Is Extremely Fragile The Fractal Structure Of The Commodity Complex Is Extremely Fragile As a reminder, a fragile fractal structure is a warning that 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. A fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. In early May, we highlighted this fragility in the commodity complex and, exactly as anticipated, most commodities then started to correct. We are trading the on-going correction in commodities through a short position in PKB as well as short CAD/USD, and both positions are now in healthy profit. Staying on the theme of commodities, the 60 percent outperformance of corn versus wheat over the past year is only starting to correct now (Chart I-11). Hence, a recommended trade is to short the corn future (number 2, yellow) versus the wheat future (number 2, soft red) setting the profit target and symmetrical stop-loss at 12 percent. Chart I-11The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct Finally, relating to a non-commodity position, we have extended by 33 days the holding period of short France versus Japan. Thus far, the position has traded sideways so we are giving it more time to move into profit. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The change in lending is the definition of the credit impulse. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Voxeu.org: Drivers of commodity price booms and busts in the long run, David Jacks and Martin Stuermer. 4 Often known as the 80-20 rule. In fact, it could be 90-10, 95-5, or even 100-5 as the numbers do not have to add up to 100. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Strong Connnection Strong Connnection Overweight The juggernaut trend in the US software & services industry is as strong as ever, and today we are reiterating our overweight call for this large sector. First, within the context of our recent recommendation to rotate into growth, software & services stocks are quintessential growth companies that outperform during periods of a growth slowdown and benefit from rate stabilization. Second, the US private fixed investment in software is going to the moon with the latest print making a 20-year high (top panel). There is no doubt that all this capex will boost both top-line and bottom-line growth. Finally, software & services earnings growth expectation data is also revealing. Sell-side analysts have completely thrown in the towel on software companies with relative forward earnings probing dotcom and GFC era Mariana Trenches (bottom panel). Bottom Line: Secular software & services growth story remains intact and we reiterate our overweight recommendation for this key sector.  

Underweight Last month, we made a final defensive tweak to our portfolio and downgraded financials from overweight to neutral by trimming banks to below benchmark allocation. One of the reasons we focused on financials specifically, was our view that the yield curve has likely peaked for this stage of the business cycle. The taper news from last week served as a catalyst bringing our view to life with the 30/5-year US Treasury yield curve flattening violently (bottom panel). The knock-on effect was felt by banks, which are down more than 10% from their peak in mid-May in relative terms (top panel). As we highlighted in previous research, any whiff of QT/taper is bearish news for yields considering the implications of an imminent liquidity withdrawal. Slightly hawkish Fed comments from last week have not been digested by the market yet, and bank stocks still have room to the downside. Once the news is fully priced in, banks will represent a good buying opportunity given our cyclical (9 to 12 months) and structural sanguine equity market views. We will be closely monitoring this call. Bottom Line: We remain underweight the S&P banks index. The position is currently up 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, PNC, TFC, FRC, FITB, SIVB, KEY, MTB, RF, CFG, HBAN, CMA, ZION, PBCT. Chart 1 An Uppercut For Banks An Uppercut For Banks    

Highlights The Auto and Components industry group is in the middle of a momentous transition to electric and autonomous-vehicle manufacturing thanks to technological advances in battery storage, AI, and radars. The entire EV cohort will benefit from government support for decarbonization, the preferences of millennials for green tech, and cutting-edge technological innovation. Further, the price of gas has recently nearly doubled, average US vehicles are more than 12 years old, while most US consumers came out of recession unscathed. Is this the time for consumers to upgrade to EVs? Legacy Automakers are to be primary beneficiaries of the theme: Higher earnings and greater economic visibility regarding EV transition should lead to further rerating of the industry group. These carmakers are also turning into Growth stocks as an expected surge in earnings is far in the future. Tesla has already had an amazing run. Even though it is 30% down from its peak, it remains expensive, and much of the growth expectations are already baked into the price. We recommend staying neutral on Tesla as it is a “cult” stock and a surge “to the moon” is not out of question. Ecosystem: The surge in EV capex and R&D spending will give a boost to the entire supply chain, which consists of chip manufacturers, battery and lidar R&D, part manufacturers, and charging networks. Many of these companies are still small. An ETF may be the best way to capture these names. Existing EV themed ETFs may not be perfect: Many have holdings that are way too broad and over-diversified, most invest outside of the US. Yet, these are the convenient vehicles to capture the theme and provide exposure to the entire EV cohort. Some of the best-known ETFs are ARKQ, DRIV, IDRV, and KARS. We believe that the EV/AV theme will outperform the US equity market over the 3-12 months horizon. Overweighting EV is also consistent with our call to rotate into Growth as higher rates and the pick up in inflation appear to be priced in. Feature Auto And Components Industry Delivers Historical Technological Advances The auto industry is undergoing a monumental shift towards electric vehicles (EV) and autonomous driving thanks to technological advances in battery storage, AI, and radars. Transition to EV is happening at a fast pace: According to IEA, the number of EVs on the road increased from about 17,000 vehicles in 2010 to 7.9 million in 2019. Autonomous vehicles (AV) are still in a testing stage, but most automakers promise to put them on the road within the next decade. LMC Automotive forecasts that that by 2031, EVs will reach 17 million units, while AVs will approach one million in 2025. Investors are cheering on this transition: The MSCI USA Auto and Components sector has outperformed MSCI USA by over 300% (408% vs. 90%) since the pandemic trough in March 2020. The EV-themed ETF DRIV outperformed by 95%. In this Special Report we provide an overview of the EV and AV industries and their emerging ecosystem. It is structured as following: First, we discuss the tailwind for transitioning towards EV. Second, we identify the key players in the EVs and AVs space. Third, we look at ways that investors can best get exposure to the EV theme and provide an investment outlook for the space. EV Tailwinds: Biden Administration Pushes Toward “Clean Tech”, Millennials Cheer The Biden administration’s push toward decarbonization of the economy will further accelerate transition towards EVs with a host of fiscal, infrastructure, and executive actions, such as tax credits, scrappage incentives, and government purchases. The White House’s $1.7-2.3 trillion infrastructure bill – which is highly likely to pass by the end of the year with green initiatives intact – includes a $15 billion buildout of 500,000 charging stations (there are currently only 27,000 in operation). Executive action by President Biden has also tightened fuel-economy standards. Individual states like California have committed to zero-emission standards by 2030. Add this to the emerging preferences of millennials for clean tech, and fully electric vehicles are expected to account for 33% of all US auto sales by 2030. Of course, there are EV adoption challenges: EV batteries remain expensive, adding approximately $10,000 to the price of a vehicle. Charging infrastructure is sparse, while EVs have relatively limited driving ranges and long charging times. But even these obstacles will be resolved sooner rather then later. According to Cathie Wood, CEO and CIO of the ARK (thematic) ETFs, EVs will approach sticker parity with gas-powered cars as soon as 2023. And there are a number of new entrants developing charging networks. Even driving ranges are increasing with Lucid promising 500 miles per charge (Chart 1). Key Players In The US Market Tesla: Enormous Potential But Competition Is Catching Up Tesla is a pioneer of battery electric vehicles (BEV), rewarded with sky-high valuations and deep pockets. Its stock had a spectacular run, rising ten-fold in two years, getting ahead of itself: It is down 30% from its January peak. So what is the bull case for Tesla that justifies the multiples, and may be considered a catalyst for future outperformance? After all, manufacturing of EVs is likely to become a highly competitive and low-margin business. Tesla has four unique advantages that constitute its competitive “moat”: An extensive supercharger network in the US and worldwide. Its push towards increased vertical integration into capabilities such as battery manufacturing and other key enabling technologies would allow it to maintain a technological edge over competition, as well as protect the company against any potential supply-chain disruptions. A mobility ecosystem, especially of data and network, turning the car into “mobile real estate”, powered by the cloud and fueled ultimately by thousands of exabytes of data. A host of auxiliary businesses: Energy, insurance, mobility/rideshare, network services and third-party battery supply. However, despite its tremendous long-term potential, Tesla has only recently become profitable (Chart 2). Further, we can’t discount a possibility that Tesla’s dominance may come to an end. Not only are Ford and GM gearing up their EV operations, but also European and Asian vehicle manufacturers such as VW, BMW, Hyundai, and Toyota present a significant competitive threat. Further, Chinese EVs, such as NIO, Geely, BYD, and XPEV, could erode Tesla’s market share in the Chinese market. Chart 1EV Will Reach Price Parity With ICE In 2023 EV Revolution EV Revolution Chart 2Tesla Has Only Recently Become Profitable Tesla Has Only Recently Become Profitable Tesla Has Only Recently Become Profitable Ford And GM Are Firmly Committed To EV Legacy automakers, such as Ford and GM, have no choice but to move aggressively into the EV space in order to survive the imminent regulatory push in Europe and the US to eliminate fossil-fuel cars. Also succeeding in the EV space is necessary to stave off competition from Tesla and other EV and legacy automakers (Chart 3). Recently, GM announced that it would accelerate its EV timeline and develop 30 new EV models by 2025, transitioning to 100% EV by 2035. It is targeting global EV sales of more than 1 million by 2025. On the heels of that announcement, Ford pledged to become all electric in Europe by 2030. The company anticipates that 40% of its global vehicle volume will be fully electric by 2030. Chart 3GM And Ford Need to Stave Off Competition From Tesla GM And Ford Need to Stave Off Competition From Tesla GM And Ford Need to Stave Off Competition From Tesla The transition to EV is a major endeavor for all legacy automakers but, if successful, they will reap significant rewards by means of higher sales and profits as EVs become increasingly more popular. They will also emerge as prime competitors of Tesla. Waymo (Alphabet) Alphabet’s Waymo launched its first autonomous ride-hailing network in Arizona but will need time and significant resources to scale nationally. The company is also developing both local and long-haul AV networks to transport goods. So far the company has not been profitable, struggling to commercialize the product efficiently. New EV Players There is a host of newcomers into the EV/AV space in the US. Furthest down the path in the light-vehicle market are Lucid, Fisker, and Electrameccanica (Solo). Workhorse Group, and the controversial Nikola are most established in the truck space. There are also EV recreational vehicle makers such as Canoe and Green Power Motors. EV/Autonomous Vehicles Ecosystem There is a brand new ecosystem developing around EVs, with suppliers providing batteries, radars, and charging stations. The industry is highly fragmented, and most smaller suppliers on the cutting edge of technological innovation are too small to be part of any index just yet or are not even public yet. Batteries The recently IPO’d QuantumScape has developed a breakthrough technology for a battery that charges in just 15 minutes. The company has received significant investment from VW. Solid Power is its newest competitor, still privately owned. Romeo Power develops batteries for big trucks, buses, and construction equipment. And XL Fleet supports EV conversions for commercial vehicles. Lidars Companies like Luminar and Velodyne use Lidar technology to improve the 3-D “vision” of the self-driving cars. These ventures demand large investments into capex and R&D, but present significant future revenue opportunities to the winners. Waymo (Alphabet) relies on Lidar technology for its fleet of AV vehicles. Charging Networks There are also a few companies focused on developing private charging networks, overcoming the main obstacle on the path to EV adoption – the need for ubiquitous availability of charging stations: ChargePoint, EVBox and Volta. Chipmakers All these vehicles are powered by chips produced by Nvidia, Qualcomm, Micron, and other semiconductor manufacturers, and technological improvements taking place in this industry are literally exponential. It is not clear yet which of these entrants are here to stay and, in a way, the EV and AV industry should remind investors of biotech: Each of these companies requires only a small allocation as part of an EV basket in order to capture the 100-bagger future winners. Where Do You Find The EV/AV Theme In Equity Indices? EV Companies And Suppliers Are Spread Across A Multitude Of Sectors This may sound like a silly question. The answer is seemingly obvious: In the Auto and Components Industry Group. However, there is a whole host of companies that are part of the ecosystem that are neither in the S&P 500/MSCI USA nor in the Auto and Components industry group. Nvidia, Micron, and Qualcomm are chipmakers assigned to the Technology sector. Alphabet’s self-driving business unit, Waymo, sits within Communications Services. Velodyne (recently added to the Russell 2000), Luminar, Quantumscape, and XL Fleet are small caps. There are also a number of special purpose acquisition companies (SPACs) that are in the process of merging with EV companies (Lucid, Faraday, ChargePoint, etc.). Auto And Components Industry Group Is Dwarfed By Tesla Moreover, a key issue with Auto and Components GICS2 is that it is dominated by a few large companies: Ford, GM, and Tesla account for 90% of the segment by market cap. The rest is divided among several autoparts manufacturers. Moreover, despite generating sales equal to only a quarter of the sales of GM or Ford (in 2020 $31 billion vs $122 billion for GM and $116 billion for Ford), Tesla alone represents roughly 3/4 of the industry group by market cap, being five times larger than Chrysler and GM combined (Chart 4). In terms of market share, Ford and GM account for 6% and 9% of global auto sales respectively, while Tesla barely even registers on a radar at 0.8%. Tesla’s dominant position holds this industry group hostage to its price performance (Chart 5). Chart 4Tesla Dominates Auto & Components Industry Group EV Revolution EV Revolution Chart 5Performance Of Auto Industry Is Held Hostage By Tesla EV Revolution EV Revolution  Therefore, it is more effective to pursue the EV theme via a more balanced and diversified custom stock basket or ETF. Having said that, because of the size of the three largest automakers, we rely on MSCI USA Auto and Components industry group as a proxy for the EV/AV investment theme for analytical purposes. EV ETFs Are Mushrooming Recently there appeared a number of ETFs powered by EV/AV themes, cutting across GICS, such as ARKQ, IDRV, KARS, and DRIV. The ETFs BATT and LIT narrowly focus on EV batteries. These ETFs contain a wide range of companies cutting across industries (See Appendix for details) Excluding the broader-themed ARKQ (Autonomous Technology and Robotics), the DRIV ETF is the most widely traded. This ETF contains all the same companies as the MSCI USA Auto and Parts industry group, but also covers the entire EV/AV supply chain from miners to companies manufacturing opto-electronic components like IIVI. DRIV contains 77 names, and ranges from giants like Tesla and Microsoft to the tiny Plug Power. It is a global ETF and includes names like Nio, VW, and Toyota. Not a single name exceeds 4% weight. DRIV is 67% correlated with MSCI USA Auto and Components, and is generally less volatile, as it is more diversified across a variety of sectors (Table 1). Table 1EV/AV ETFs EV Revolution EV Revolution Key Revenue Drivers Reopening Trade And Global Growth Acceleration The Automobiles and Components industry group is a classic early cyclical, highly geared to economic growth, outperforming during the recovery stage of the business cycle. Global reopening has resulted in a sharp global growth acceleration and benefited US automakers’ sales at home and abroad. Indeed, total vehicle sales in the US have already exceeded pre-pandemic levels. The question is whether this surge may continue with a backdrop of a growth slowdown (albeit off high levels) and how fast supply-chain disruptions will be resolved. Consumers Are Flush With Cash Most vehicles are sold to consumers, whose sentiment and financial wellbeing are the key industry drivers. Ubiquitous vaccination and economy-wide reopening is increasing employment in the lower-paid cohorts most affected by lockdowns. Expiration of unemployment benefits and school reopening will see millions more returning to work this fall. Anticipating a surge in employment, consumer confidence has started to rebound, albeit off low levels. The most recent $1.9 trillion fiscal stimulus package with its $1,400 checks cut directly to consumers, bodes well for US auto sales. For many vehicles, this amount may be sufficient for a down-payment. Personal savings have increased by roughly $1.5 trillion from the January 2020 trough, and disposable income has increased by 6%. Coupled with low interest rates and an improvement in banks’ willingness to lend, US consumers are in an excellent shape to upgrade their vehicles (Charts 6 & 7). Chart 6Demand For Auto Loans Has Picked Up Demand For Auto Loans Has Picked Up Demand For Auto Loans Has Picked Up Chart 7Lending Standards for Auto Loans Eased Up Lending Standards for Auto Loans Eased Up Lending Standards for Auto Loans Eased Up However, plans to buy a new car have declined recently due to car shortages and a spike in prices. Supply Chain Disruptions Hurt Demand For Vehicles Pandemic has brought about unique challenges: Global pent-up demand and COVID-induced supply-chain disruptions led to a mismatch between supply and demand and resulted in sharp price acceleration across a wide range of goods. US automakers have been hit hard by the global chip shortage, resulting in plant shutdowns and lower output in some cases. Shortages of lithium, a key component of EV batteries, led to its price doubling. Transportation networks are also choked up, and delivery costs are up more than 30%. While these post-pandemic difficulties are transitory in nature, prices of vehicles spiked, making it the most volatile component of the latest CPI reading, with prices in May rising 16% YoY (Chart 8). Higher price tags and half-empty car lots at dealerships are dampening consumers’ intentions to upgrade their vehicles, despite their present financial wellbeing (Chart 9). Chart 8Prices Of Cars Surged Prices Of Cars Surged Prices Of Cars Surged Chart 9Supply Disruption Dampened Demand For Vehicles Supply Disruption Dampened Demand For Vehicles Supply Disruption Dampened Demand For Vehicles According to IHS Markit, the average age of vehicles on US roadways rose to a record 12.1 years last year, as lofty prices and improved quality prompted owners to hold on to their cars for longer. The average price for a new vehicle is $38,000, which is expensive for most Americans. However, there are early signs that supply disruptions are starting to dissipate: Production of motor vehicles rose 6.7% in May compared with a 5.7% decrease a month earlier. Once vehicle prices stabilize, or even correct, sales are likely to rebound. EV also enjoy a unique tailwind: The price of gasoline has doubled since the beginning of the year, making electric vehicles a more attractive proposition than gas-guzzling alternatives. Weaker Dollar Boosts Foreign Sales USD has weakened by 8% since the beginning of the pandemic. This bodes well for the US auto and parts manufacturers who derive about 1/3 of revenues from outside the US. A weaker USD not only stimulates demand by making vehicles cheaper for foreign buyers but will also benefit manufacturers' income statements via a currency-translation effect (Chart 10). Chart 10Weaker Dollar Boosts Foreign Sales Weaker Dollar Boosts Foreign Sales Weaker Dollar Boosts Foreign Sales Profitability Of Automakers Belt-tightening Of 2020 Is Unsustainable Margin compression has been a problem for the industry group for a while as a race to enhance existing vehicles and transition to EV has been weighing on profitability (Chart 11). However, in 2020, despite a dip in sales volume, US automakers were able to successfully manage margins, by reducing R&D expenses, capex, and labor costs, and by halting increases in dividends and buybacks, and enjoying lower prices of industrial metals. Maintaining this new lean cost structure is hardly sustainable. Chart 11Margins Are Under Pressure Margins Are Under Pressure Margins Are Under Pressure R&D And Capex Will Rise As Technological Innovation Demands Capital Outlays R&D and capex are likely to increase for the entire group. Legacy automakers are forced to operate on two distinct timelines by managing and investing in the immediate conventional vehicle production cycle, while concurrently preparing for the longer-term transition to a world of vehicle electrification and autonomous driving. Development of EVs requires deep pockets and substantial investments into both capex and R&D, which have been steadily rising (Charts 12 & 13). Chart 12R&D Expense Is Bound To Increase… R&D Expense Is Bound To Increase… R&D Expense Is Bound To Increase… Chart 13… As Is Capex EV Revolution EV Revolution Case in point, GM has recently announced a $35 billion investment into EV and AV, an increase of 75% from its initial pledge, an amount exceeding its gas and diesel investment. Not to be outdone, Ford has copied the move, pledging $30 billion on EV vehicle development, including battery development, by 2025. This is an increase of more than 35% over the $22 billion previously pledged. Clearly, commitment to EV siphons resources away from other businesses, and put pressures on automakers to keep up with competitors. Yet the market applauded these announcements by bidding up shares of both companies, implicitly saying that EV spending will lead to better future cashflows. Thus transition to EV moves auto stocks from the Value into the Growth camp, making the group more sensitive to interest rates. Runaway Cost Of Raw Materials Is Stabilizing Metals such as steel, iron, and aluminum comprise over 75% of the content of the car. The price of metals is particularly important to EV manufacturers as the body of an EV contains five times more steel than regular vehicles. In 2020 gross margin benefited from a dip in prices of industrial metals. However, the recent economic recovery has led to a rebound in the prices of commodities, with the GSCI Industrial Metals Index rising by more than 70% off the bottom and reaching 2010 levels (Chart 14). There are early signs that prices are stabilizing: The price of steel is down by 20%, copper by 13%, and aluminum by 6%, from their respective peaks (Chart 15). Chart 14Price Of Industrial Metals Have Spiked... Price Of Industrial Metals Have Spiked... Price Of Industrial Metals Have Spiked... Chart 15...But There Are Early Signs Of Correction ...But There Are Early Signs Of Correction ...But There Are Early Signs Of Correction High Operating Leverage Of Auto Manufacturers Amplified Earnings Growth Automakers and suppliers have high fixed-cost manufacturing facilities. As a result, their operating leverage is high, i.e., increases in sales are translated into even greater increases in profits. As 2021 sales are expected to rise, earnings will also continue to rebound, reaching or even exceeding pre-pandemic levels. Looking ahead, we expect earnings growth to decelerate as sales are likely to normalize while EV transitioning costs will continue to rise (Chart 16). However, eventually, EV investment will translate into higher sales volumes: Once new technology infrastructure is in place, the long-term profitability of the industry group will improve. Chart 16Earnings Are Rebounding To Pre-pandemic Levels Earnings Are Rebounding To Pre-pandemic Levels Earnings Are Rebounding To Pre-pandemic Levels Valuations: Significant Dispersion Within Industry Group The auto and parts industry has been underperforming the market since February 2020, with valuations coming down significantly. Looking under the hood, we observe a pronounced bifurcation between Tesla and other stocks (Table 2). Table 2Tesla Is Still Expensive, Ford and GM Are Cheap EV Revolution EV Revolution Tesla trades at an eye-watering 596x earnings (which is an improvement from 1,300x back in January) and 16.3x sales multiple. The company has enormous long-term potential, but over the short term it needs to grow into its valuations, as it has effectively “borrowed” returns from the future. Yet investors need to keep in mind that Tesla is a cult stock, and has a strong retail following: Continuation of an irrational speculative bubble is within the realm of possibility. Therefore, a neutral allocation to Tesla will be prudent. Legacy automakers and suppliers are still cheap despite a strong run off their market lows. Forward 12-month PE is in the single/low-double digit range. Low valuations indicate that there is still an overhang of uncertainty over the economic recovery and potential profitability of legacy car manufacturers and suppliers, along with lingering doubts about the success of the group in the EV space. However, there is a lot of room for long-term rerating once there is greater visibility (Chart 17). Chart 17With Tesla Down 30% From Peak, Industry Group Looks Cheaper With Tesla Down 30% From Peak, Industry Group Looks Cheaper With Tesla Down 30% From Peak, Industry Group Looks Cheaper Investment Outlook We have a positive 3-12-month outlook for the investment performance of the EV theme: The entire EV cohort will benefit from government support for decarbonization, the preference of millennials for green tech, and cutting-edge technological innovation. American vehicles are getting old, and consumers have financial resources to purchase new cars. Supply disruptions are gradually dissipating. Gasoline is getting expensive, but EV/ICE parity is near. Investing in automakers and suppliers, which are turning into growth companies with longer duration of cash flows, is also aligned with our thesis of rotating into Growth as rates have stabilized and the pick up in inflation has been priced in. Legacy Automakers are to be primary beneficiaries of the theme. Both Ford and GM are relatively inexpensive. Higher earnings and improved visibility on the success of EV transition should lead to further rerating. Tesla is also a quintessential growth company. However, unlike legacy automakers, it has already had an amazing run. Even though it is down from its peak, it remains expensive, and much of the positive expectations are already baked into price. We recommend staying neutral on Tesla as it is a “cult” stock and a surge “to the moon” is not out of the question. Ecosystem Surge in EV capex and R&D spending will have positive spill-over effect on EV ecosystem suppliers. These are small cap stocks and creating a well-diversified basket of names in battery, radar, chips and software will help capture returns of the long-term winners. Existing EV-themed ETFs may not be perfect: Many have holdings that are way too broad and over diversified, most invest outside of the US. Yet, these are convenient vehicles to capture the theme and provide exposure to the entire EV value chain, including emerging industry players. Bottom Line: The auto industry is undergoing a major technological disruption. This process is expensive and perilous yet presents an enormous future earnings growth opportunity. The ingredients for success are in place: Proliferation of new technologies, government support, changing consumer preferences, and surging US economy. This tide will lift all boats: Legacy and EV-only auto manufacturers and suppliers as well as EV ecosystem players. We are bullish on the sector on a 3-12 months investment horizon.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Appendix Table A1EV/AV ETF Summary EV Revolution EV Revolution Recommended Allocation EV Revolution EV Revolution

Highlights Tactically downgrade cyclical equities from overweight in Europe. The shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries create headwinds for the cyclicals-to-defensives ratio this summer. Weaker global inflation expectations, commodity prices, and a dollar rebound will accompany this period of turbulence. The relative technical and valuation backdrop will also contribute to this period. Short consumer discretionary / long telecommunication is a high-octane version of the trade. Short technology / long healthcare is its lower-risk / lower-reward cousin. This temporary portfolio shift is a risk management move to capitalize on our positive 18- to 24- month view on cyclicals. Feature Last week, we recommended investors adopt a more defensive tactical posture.  They should raise cash and shift into defensive quality names in order to weather a summer replete with potential downside risk. This will place investors in a good position to shift back into a more aggressive stance this fall, when cyclical sectors should resume their outperformance. This week, we explore this idea in more detail. The combination of a Chinese credit slowdown, a potential transition in the driver of growth away from goods into services, and a shift in tone from global central banks will feed the expected market volatility this summer. European defensive stocks are set to outperform during this period. Buying telecommunication equities / selling consumer discretionary stocks is a high octane bet on this trend, while going long healthcare / short technology shares is its low-risk incarnation. Summer Storms This summer, three forces will feed some downside risk in the market and, more specifically, an underperformance of cyclical sectors relative to defensive ones: a transition in global growth, preliminary signs that global central banks will begin to take away the punch bowl, and disappointments caused by COVID variants. Growth Transition The global economy is set to cool down as we transition away from the first stage of the post-pandemic recovery. As we showed last week, China’s deteriorating credit impulse is consistent with global industrial activity receding from its extremely robust pace of expansion (Chart 1). The continued decline in China’s banking system excess reserve ratio suggests that total social financing flows will slow further. Consequently, China’s intake of raw materials and industrial goods will decelerate, which will impact global industrial activity negatively. Already, the New Orders component of China’s Manufacturing PMI has rolled over. The disappointment of Chinese retail sales last week further indicates that China will act as a drag on global growth in the coming quarters. We have also highlighted that the combined effect of higher yields and oil prices has become strong enough to alter negatively the path of global industrial activity going forward. Our Global Growth Tax indicator, which includes both variables, shows that the US ISM Manufacturing survey and the global manufacturing PMI have reached their apex and will moderate this summer (Chart 2). Chart 1The China Drag The China Drag The China Drag Chart 2Rising Costs Bite Rising Costs Bite Rising Costs Bite The problem for global growth is one of changing leadership. Global economic activity is not about to collapse, but the extraordinary surge in goods consumption that started in 2020 will make room for a catch-up in the service sector. As an example, US retail sales stand 15% above their pre-pandemic trends; however, services spending still lies 7% below its pre-pandemic tendency (Chart 3). Thus, as summer progresses, the recent deceleration in consumer spending on goods will continue and services will progressively pick up the slack. The change in growth leadership will cause some temporary trepidation in global economic activity, because it is happening when the effect of both the Chinese credit slowdown and the previous increase in yields and oil will be most potent. As a result, we expect the G-10 Economic Surprises Index to follow that of China and experience an air pocket this summer (Chart 4). Chart 3From Goods To Services From Goods To Services From Goods To Services Chart 4Where China Goes, So Will The G-10 Where China Goes, So Will The G-10 Where China Goes, So Will The G-10   The Chaperone Is On The Way More than 65 years ago, former Fed Chair William McChesney Martin noted that the job of central bankers was to be “the chaperone who has ordered the punch bowl removed just as the party was really warming up.” Chart 5The Chaperone Is Waking Up The Chaperone Is Waking Up The Chaperone Is Waking Up Today, the party is a rager, and central bankers are indicating that they will remove the punch bowl soon. Real estate speculation is worrying the Bank of Canada, and its balance sheet has already shrunk by C$99 billion, to C$476 billion. The Norges Bank has indicted that it will lift interest rates twice this year. The Reserve Bank of New Zealand is set to lift the Official Cash Rate soon. The Bank of England has begun to adjust its asset purchases and could begin a full-fledge tapering this year. The 800-pound gorilla is the Fed, which telegraphed more clearly last week its intention to raise rates twice in 2023, and therefore moved closer to the pricing of the OIS curve (Chart 5). Implied in this forecast, the Fed will start tapering its asset purchase in early 2022 at the latest. This change in tone by global central banks is not a major problem for the business cycle – global rates are still far below any reasonable estimates of the neutral rate of interest, but periods of transition in monetary policy are often associated with transitory market turbulences. This time will not be an exception, especially because it is happening when global growth is downshifting. Delta, Gamma, Epsilon, etc? Chart 6Depressed Macro Volatility Depressed Macro Volatility Depressed Macro Volatility With the rapid progress of vaccination, the worst of the COVID tragedy is behind us. Nonetheless, the pandemic is not yet fully in the rear-view mirror, not even in the Western nations that lead the global inoculation campaign. SARS-CoV-2 continues to evolve and will therefore produce new variants over time, some of which will be problematic. The UK illustrates this phenomenon. The government has postponed the so-called Freedom Day, when life returns to normal, by five weeks despite the country’s high vaccination rate. The Delta variant is significantly increasing among the unvaccinated and not fully inoculated Britons. Many countries will also face this problem. These delays will be minor and will not threaten national recoveries. However, they will feed market tensions in a context where global macro volatility is low (Chart 6), global growth is already peaking, and monetary accommodation is receding. Global Market Implications… The confluence of the change in global economic growth leadership, the upcoming liquidity removal, and the potential for short-lived delays to the global economic re-opening point toward a decline in global inflation expectations, a rebound in the US dollar, weaker commodity prices, and an underperformance of global cyclical relative to defensive equities. Over the coming months, inflation breakeven rates are likely to soften, while real yields will rise modestly. In May, US inflation breakeven rates peaked near 2.6%, their highest level in ten years. A weaker global growth impulse in combination with a Fed that is more willing to remove some monetary accommodation will cool inflationary fears among investors and cause inflation expectations to decline further. However, the specter of tighter policy will also support TIPS yields. Bond yields are likely to correct somewhat more over the summer. Bond prices have not yet fully purged their oversold conditions (Chart 7); thus, a decrease in inflation expectations will temporarily support Treasury prices, even if real yields do not fall. Recent market action is moving in this direction. Last week, by Thursday evening, 10-year Treasury yields had already lost their 9 bps rise that followed Wednesday’s FOMC meeting. 30-year Treasury yields have plunged to a four-month low. Bund yields are unable to hang on to their gains either. The dollar has more upside this summer. Higher real US yields offer a potent backing for a DXY that still refuses to drop below 89. Moreover, the greenback is a highly counter-cyclical currency and is particularly sensitive to the gyrations in the global industrial cycle. Thus, the deceleration in the global manufacturing cycle will create a temporary tailwind for the greenback. Over the past three years, the gap between US TIPS yields and the Chinese Economic Surprise index explained the fluctuation of the DXY; it currently points toward a continued rebound in the USD (Chart 8). Even if this move is ephemeral, it will have implications for investors this summer. Chart 7Technical Backdrop For Bonds Technical Backdrop For Bonds Technical Backdrop For Bonds Chart 8Near-Term Upside For The DXY Near-Term Upside For The DXY Near-Term Upside For The DXY Commodities will also suffer. Natural resource prices have rallied in a parabolic fashion and our Composite Technical Indicator is massively overbought (Chart 9). Meanwhile, Chinese authorities are verbally jawboning industrial metal prices and have begun to release copper, zinc, aluminum, and nickel from their stockpiles. In this context, the Chinese credit slowdown and the imminent removal of monetary accommodation in various corners of the globe will catalyze a correction in commodities, even if a new supercycle has begun. The recent travails of lumber prices, which have collapsed 47% since May 7 (while they still remain in technical bull market!), may constitute a canary in the coalmine for the wider commodity complex. Global cyclical equities have greater downside against their defensive counterparts. US markets are global trendsetters; while the S&P cyclicals have lost some altitude compared to defensives, they have yet to purge their oversold state and remain very expensive (Chart 10). This backdrop makes them vulnerable to slowing Chinese import growth, a stronger dollar, and weaker commodity prices. Chart 9Will The GSCI Follow Lumber? Will The GSCI Follow Lumber? Will The GSCI Follow Lumber? Chart 10Vulnerable Global Cyclicals Vulnerable Global Cyclicals Vulnerable Global Cyclicals   … And European Investment Implications Chart 11European Cyclicals Are Also At Risk European Cyclicals Are Also At Risk European Cyclicals Are Also At Risk The European cyclicals-to-defensives ratio is vulnerable, like it is in the US. Hence, a more defensive portfolio bias makes sense for the summer, which should allow investors to regain maximum cyclical exposure later this year. Short consumer discretionary / long telecommunications and short technology / long healthcare are pair trades with particularly attractive risk profiles. The cyclicals-to-defensives ratio is technically unattractive. The relative share prices stand toward the top of their 16-year trading range (Chart 11). Moreover, their 52-week momentum measure is rolling over at a highly elevated level, while the 13-week rate of change is deteriorating. Meanwhile, the Combined Mechanical Valuation Indicator1 (CMVI) of the cyclicals towers far above that of the defensives and is consistent with a corrective episode (Chart 11, bottom panel). The drivers of the performance of Eurozone cyclical relative to defensive sectors confirm that cyclicals could suffer a turbulent summer. For instance: The potential for further declines in global yields does not bode well for the European cyclicals-to-defensives ratio (Chart 12). Weaknesses in market-based inflation expectations would prove particularly threatening (Chart 12, bottom panel). The deceleration in China’s total social financing flows anticipates an underperformance of European cyclicals (Chart 13). As China’s credit decelerates, so will the earnings revisions of cyclical equities. Moreover, a weaker Chinese TSF is consistent with falling Treasury yields. Chart 12Lower Inflation Expectations Equals Underperforming Cyclicals Lower Inflation Expectations Equals Underperforming Cyclicals Lower Inflation Expectations Equals Underperforming Cyclicals Chart 13Cyclicals Listen To China Cyclicals Listen To China Cyclicals Listen To China The potential for weaker commodity prices is another problem for European cyclical equities (Chart 14). Commodities capture the ebb and flow of global growth sentiment, which is also a driver of the earnings revisions of cyclicals relative to defensives. Moreover, commodity prices greatly affect the earnings of cyclical equities. Unsurprisingly, the momentum of the European cyclicals-to-defensives ratio correlates closely with the BCA Commodity Composite Technical Indicator (Chart 14, bottom panel). Cyclicals perform poorly when the dollar appreciates. The Eurozone’s cyclicals-to-defensives ratio moves in lock-step with the euro and high-beta cyclical currencies (Chart 15). These relationships reflect the counter-cyclicality of the dollar, as well as the negative effect on global financial conditions of its rallies, and thus, on the earnings outlook for cyclicals. Chart 14Beware The Impact Of Weaker Commodities Beware The Impact Of Weaker Commodities Beware The Impact Of Weaker Commodities Chart 15A Strong Dollar Hurts European Cyclicals A Strong Dollar Hurts European Cyclicals A Strong Dollar Hurts European Cyclicals Chart 16Short Consumer Discretionary And Long Telecommunication Short Consumer Discretionary And Long Telecommunication Short Consumer Discretionary And Long Telecommunication Based on these observations, we are tactically downgrading cyclicals from our overweight stance for the summer, despite our conviction that cyclicals have upside on an 18- to 24-month basis. We look at this move as risk management. For investors looking to bet on a potential underperformance of cyclical equities in Europe, we recommend two positions: a high-octane pair trade and a lower-risk one. The high-octane version is to sell consumer discretionary stocks and buy telecommunications ones (Chart 16). This pair trade is exposed to lower yields, lower inflation expectations, and the shift in growth drivers from China and goods consumption to services expenditures. Additionally, the relative 52-week momentum measure is overextended, while the 13-week rate of change is already sagging. The CMVI of the consumer discretionary sector is extremely elevated, while that of telecommunication stocks is the most depressed of any Eurozone sector. Consequently, the gap between the two sectors’ CMVI stands at nearly three-sigma, which is concerning because the RoE of consumer discretionary shares lies 7% below that of the telecoms industry (Chart 16, third and fourth panel). Because higher RoEs should justify higher valuations, consumer discretionary and telecommunication stand out as the greatest outliers among European sectors (Chart 17). As an added benefit, this trade enjoys a positive dividend carry of more than 2.5%. Chart 17Spot The Outliers Summertime Blues Summertime Blues Chart 18Short Technology And Long Healthcare Short Technology And Long Healthcare Short Technology And Long Healthcare The low octane pair trade is to sell technology stocks and buy healthcare names instead. This position offers lower expected returns but also a lower risk, because both sectors are growth stocks and they will benefit from falling yields and inflation expectations. However, based on their respective CMVI, tech equities are much more expensive than healthcare ones (Chart 18), while they are also extremely overbought. Thus, healthcare should benefit more from falling yields and inflation expectations than tech. Moreover, technology is a more cyclical sector than healthcare; it will therefore be more sensitive to the evolution of global growth. Bottom Line: We remain positive on the outlook for cyclical equities on an 18- to 24-month horizon, but the changing global growth leadership, the imminent removal of global monetary accommodation, and the demanding valuation and technical backdrop of the European cyclicals-to-defensives ratio suggest that a period of turbulence will materialize this summer. Thus, we are tactically downgrading cyclicals. Investors should consider going long telecommunications / short consumer discretionary as a high-octane tactical bet on this portfolio stance. Buying healthcare / selling technology would constitute a lower risk / lower return play. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Footnotes 1 For a detailed explanation of the Combined Mechanical Valuation Indicator, see Special Report, “Valuation – A Mechanical Approach,” dated May 31, 2021. Currency Performance Summertime Blues Summertime Blues Fixed Income Performance Government Bonds Summertime Blues Summertime Blues Corporate Bonds Summertime Blues Summertime Blues Equity Performance Major Stock Indices Summertime Blues Summertime Blues Geographic Performance Summertime Blues Summertime Blues Sector Performance Summertime Blues Summertime Blues

Dear Client, Next week, instead of our regular report, we will be sending you a Special Report from BCA Research’s MacroQuant tactical global asset allocation team. Titled “MacroQuant: A Quantitative Solution For Forecasting Macro-Driven Financial Trends,” this white paper will discuss the purpose, coverage, and methodology of the MacroQuant model. I hope you will find the report insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets for the rest of 2021 and beyond. We will also be holding a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) to discuss the outlook. Best regards, Peter Berezin Chief Global Strategist Highlights Although the Fed delivered a hawkish surprise on Wednesday, monetary policy is likely to remain highly accommodative for the foreseeable future. We continue to see high US inflation as a long-term risk rather than a short-term problem. Outside of a few industries, wage inflation remains well contained. In those industries suffering from labor shortages, the expiration of emergency unemployment benefits, increased immigration, and the opening up of schools should replenish labor supply. Bottlenecks in the global supply chain are starting to ease. Many key input prices have already rolled over, suggesting that producer price inflation has peaked and is heading down. A slowdown in Chinese credit growth could weigh on metals prices during the summer months, which would further temper inflationary pressures. We are downgrading our view on US TIPS from overweight to neutral. Owning bank shares is a cheaper inflation hedge. Look Who’s Talking The Fed jolted markets on Wednesday after the FOMC signaled it may raise rates twice in 2023. Back in March, the Fed projected no hikes until 2024 (Chart 1). Chart 1Fed Forecasts Converge Toward Market Expectations Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Seven of 18 committee members expected lift-off as early as 2022, up from four in March. Only five participants expected the Fed to start raising rates in 2024 or later, down from 11 previously. The Fed acknowledged recent upward inflation surprises by lifting its forecast of core PCE inflation to 3.4% for 2021 compared with the March projection of 2.4%. These forecast revisions bring the Fed closer to market expectations, although the latter are proving to be a moving target. Going into the FOMC meeting, the OIS curve was pricing in 85 bps of rate tightening by the end of 2023. At present, the market is pricing in about 105 bps of tightening. At his press conference, Chair Powell acknowledged that FOMC members had discussed scaling back asset purchases. “You can think of this meeting as the ‘talking about talking about’ meeting,” he said. A rate hike in 2023 would imply the start of tapering early next year. The key question for investors is whether this week’s FOMC meeting marks the first of many hawkish surprises from the Fed. We do not think it does. As Chair Powell himself noted, the dot-plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” Ultimately, a major monetary tightening cycle would require that inflation remain stubbornly high. As we discuss below, while there are good reasons to think that the US economy will eventually overheat, the current bout of inflation is indeed likely to be “transitory.” This implies that bond yields are unlikely to rise into restrictive territory anytime soon, which should provide continued support to stocks. Inflation: A Long-Term Risk Rather Than A Short-Term Problem Chart 2Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago There are plenty of reasons to worry that US inflation will eventually move persistently higher. As we discussed in a recent report, many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 2). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over unruly global supply chains. Baby boomers are leaving the labor force en masse. As a group, baby boomers control more than half of US wealth (Chart 3). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Chart 3Baby Boomers Have Accumulated A Lot Of Wealth Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Despite a pandemic-induced bounce, underlying productivity growth remains disappointing (Chart 4). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 5). Chart 4Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Chart 5Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Perhaps most importantly, policymakers are aiming to run the economy hot. A tight labor market will lift wage growth (Chart 6). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Despite these structural inflationary forces, history suggests that it will take a while – perhaps another two-to-four years – for the US economy to overheat to the point that persistently higher inflation becomes a serious risk. Consider the case of the 1960s. While the labor market reached its full employment level in 1962, it was not until 1966 – when the unemployment rate was a full two percentage points below NAIRU – that inflation finally took off (Chart 7). Chart 6A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In May, 4.4% fewer Americans were employed than in January 2020 (Chart 8). The employment-to-population ratio for prime-aged workers stood at 77.1%, 3.4 percentage points below its pre-pandemic level (Chart 9). Chart 8US Employment Still More Than 4% Below Pre-Pandemic Levels Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 9Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels Prime-Age Employment-To-Population Ratio Remains Below Pre-Pandemic Levels A Labor Market Puzzle Admittedly, if one were to ask most companies if they were finding it easy to hire suitable workers, one would hear a resounding “no.” According to the National Federation of Independent Business (NFIB), 48% of firms reported difficulty in filling vacant positions in May, the highest share in the 46-year history of the survey (Chart 10). Chart 10US Labor Market Shortages (I) US Labor Market Shortages (I) US Labor Market Shortages (I) Chart 11US Labor Market Shortages (II) US Labor Market Shortages (II) US Labor Market Shortages (II)   Nationwide, the job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The share of workers quitting their jobs voluntarily – a measure of worker confidence – also hit a record of 2.7% (Chart 11). How can we reconcile the apparent tightness in the labor market with the fact that employment is still well below where it was at the outset of the pandemic? Four explanations stand out. First, unemployment benefits remain extremely generous. For most low-wage workers, benefits exceed the pay they received while employed. It is not surprising that labor shortages have been most pronounced in sectors such as leisure and hospitality where average wages are relatively low (Chart 12). The good news for struggling firms is that the disincentive to working will largely evaporate by September when enhanced unemployment benefits expire. Chart 12Labor Scarcity Prevalent In Low-Wage Sectors Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 13School Closures Have Curbed Labor Supply Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Second, lingering fears of the virus and ongoing school closures continue to depress labor force participation. Chart 13 shows that participation rates have recovered less for mothers with young children than for other demographic groups. This problem will also fade away by the fall when schools reopen. Third, the number of foreign workers coming to the US fell dramatically during the pandemic. State Department data show that visas dropped by 88% in the nine months between April and December of last year compared to the same period in 2019 (Chart 14). President Biden revoked President Trump’s visa ban in February, which should pave the way for renewed migration to the US. Chart 14US Migrant Worker Supply Is Depressed Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Chart 15The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement   Fourth, about 1.5 million more workers retired during the pandemic than one would have expected based on the pre-pandemic trend (Chart 15). Most of these workers were near retirement age anyway. Thus, there will likely be a decline in new retirements over the next couple of years before the baby boomer exodus described earlier in this report resumes in earnest. Other Input Prices Set To Ease Just as labor shortages in a number of industries will ease later this year, some of the bottlenecks gripping the global supply chain should also diminish. The prices of various key inputs – ranging from lumber, steel, soybeans, corn, to DRAM prices – have rolled over (Chart 16). This suggests that producer price inflation for manufactured goods, which hit a multi-decade high of 13.5% in May – has peaked and is heading lower. Chart 16Input Prices Have Rolled Over Input Prices Have Rolled Over Input Prices Have Rolled Over The jump in prices largely reflected one-off pandemic effects. For example, rental car companies, desperate to raise cash at the start of the pandemic, liquidated part of their fleets. Now that the US economy is reopening, they have found themselves short of vehicles. With fewer rental vehicles hitting the used car market, households flush with cash, and new vehicle production constrained by the global semiconductor shortage, both new and used car prices have soared. Vehicle prices have essentially moved sideways since the mid-1990s (Chart 17). Thus, it is doubtful that the recent surge in prices represents a structural break. More likely, prices will come down as supply increases. According to a recent report from Goldman Sachs, auto production schedules already imply an almost complete return to January output levels in June. Chart 17Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Vehicle Prices Have Essentially Moved Sideways Since The Mid-1990s Chart 18Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet As Chart 18 shows, more than half of the increase in consumer prices in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI remains below its pre-pandemic trend (Chart 19). Chart 19Unwinding Of "Base Effects" Unwinding Of "Base Effects" Unwinding Of "Base Effects"   Chart 20"Supercore" Inflation Measures Remain Well Contained "Supercore" Inflation Measures Remain Well Contained "Supercore" Inflation Measures Remain Well Contained More refined measures of underlying inflation such as the trimmed-mean CPI, median CPI, and sticky price CPI are all running well below their official core CPI counterpart (Chart 20). While certain components of the CPI basket, such as residential rental payments, are likely to exhibit higher inflation in the months ahead, others such as vehicle and food prices will see lower inflation, and perhaps even outright deflation. Slower Chinese Credit Growth Should Temper Commodity Inflation Chart 21Chinese Credit Growth And Metal Prices Move Together Chinese Credit Growth And Metal Prices Move Together Chinese Credit Growth And Metal Prices Move Together Chinese credit growth and base metals prices are strongly correlated (Chart 21). We do not expect the Chinese authorities to embark on a new deleveraging campaign. Credit growth has already fallen back to 11%, which is close to the prior bottom reached in late-2018. Nevertheless, to the extent that changes in Chinese credit growth affect commodity prices with a lag of about six months, metals prices could struggle to maintain altitude over the summer months. China’s plan to release metal reserves into the market could further dampen prices. We remain short the global copper ETF (COPX) relative to the global energy ETF (IXC) in our trade recommendations. The trade is up 18.4% since we initiated on May 27, 2021. We will close this trade if it reaches our profit target of 30%. Bank Shares Are A Better Hedge Against Inflation Than TIPS We have been overweight TIPS in our view matrix. However, with 5-year/5-year forward breakevens trading near pre-pandemic levels, any near-term upside for inflation expectations is limited (Chart 22). As such, we are downgrading TIPS from overweight to neutral in our fixed-income recommendations. Investors looking to hedge inflation risk should consider bank shares. Our baseline view is that the 10-year Treasury yield will rise to about 1.9% by the end of the year. If inflation fails to come down as fast as we anticipate, bond yields would increase even more than that. Chart 23 shows that banks almost always outperform the S&P 500 when bond yields are rising. Chart 22Limited Near-Term Upside For Inflation Expectations Limited Near-Term Upside For Inflation Expectations Limited Near-Term Upside For Inflation Expectations Chart 23Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment   Banks are also cheap. US banks trade at 12.2-times forward earnings compared with 21.9-times for the S&P 500. Non-US banks trade at 10-times forward earnings compared to 16.4-times for the MSCI ACW ex-US index. Finally, we like gold as a long-term inflation hedge. We would go long gold in our structural trade recommendations if the price were to fall to $1700/ounce. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Special Trade Recommendations Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet Current MacroQuant Model Scores Don’t Sweat US Inflation…Just Yet Don’t Sweat US Inflation…Just Yet

Highlights New variants of SARS-Cov-2 will create new waves of infection, the inflation bubble is bursting, and massive slack in the US labour market will keep US inflation structurally subdued. The coming years will be defined by a trifecta of surging productivity, massive slack in the labour market, and ultra-low inflation.  Overweight US T-bonds both tactically and structurally. Equity investors should overweight growth versus value… …overweight defensives versus cyclicals… …overweight the US versus the euro area… …and overweight DM versus EM, both tactically and structurally. Tactically underweight US REITS. Tactically overweight Nike versus L’Oréal. Feature Chart of the WeekThe Global Pandemic Is Still In Flow Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade The UK will have to wait for its ‘freedom day.’ Lifting the remaining pandemic-related restrictions has been postponed because a new and more vaccine-resistant ‘delta’ variant of the virus is threatening to unleash a third wave of UK infections. The UK experience is important because it was the first major developed economy to roll out its mass vaccination program. Thereby, the UK experience could be the harbinger of things to come in other major economies like the US and the euro area. Vaccines Against RNA Viruses Are Not Highly Effective The general public and financial markets have high expectations that mass vaccination programs can banish Covid forever. Such expectations are unrealistic, just as it is unrealistic to expect vaccinations to banish the flu forever. It is unrealistic to expect vaccinations to banish Covid forever. Covid, the flu, and measles are all diseases caused by ‘RNA viruses.’ The defining characteristic of RNA viruses is their poor proofreading ability during replication, resulting in high rates of mutation. The resulting variant strains make RNA viruses highly effective at evading vaccinations. As the Journal of Immunology Research puts it:1 “No vaccine or specific treatment is available for many of these RNA viruses and some of the available vaccines and treatments are not highly effective.” Measles is an exception because its virus is ‘antigenically monotypic.’ The spike proteins (antigens) that the measles virus uses to infect a cell cannot mutate even slightly without breaking. However, the SARS-CoV-2 spike proteins can mutate and still infect. This we know because the virus has already evolved several infectious variants – including the latest delta variant – with increasing abilities to evade the current spike-based vaccines (Figure I-1). Figure I-1How Variants Of SARS-CoV-2 Evade Spike-Based Vaccines Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade SARS-Cov-2 doesn’t care who it infects or in which country they live. Sadly, the pandemic has claimed more fatalities in the first half of 2021 than in the whole of 2020 (Chart of the Week). And the virus will continue to mutate liberally given that its reproduction rate is still close to 1 (Chart I-2).   Chart I-2The Reproduction Rate Is Still Close To 1 Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Crucially, the mutations of the virus that evade vaccinations are the ones that are more likely to spread and become the new dominant strains. After the delta variant will come the epsilon variant, the zeta variant, the eta variant… and so on until we run out of Greek alphabet. In which case, should we just adopt the same strategy for Covid as we use for the seasonal flu – remove all pandemic-related restrictions, while offering booster vaccinations to the most medically vulnerable once or twice a year? There are two problems with this strategy: First, it could still overwhelm our healthcare systems during surges in demand. This we know because a bad flu season, by itself, was already pushing some healthcare systems to the limit. There is very little spare capacity to cope with additional demand. Second, unlike the flu, Covid appears to have long-term sequelae, colloquially called ‘long Covid’ with unknown chronic damage to health. As the Lancet points out: “Long-term sequelae of Covid-19 are unknown… we owe good answers on the long-term consequences of the disease to our patients and healthcare providers” Without these answers, policymakers cannot adopt the same strategy for Covid as for the flu. So yes, we can certainly offer vaccinations to the most medically vulnerable once or twice a year. But managing infections will also require non-pharmaceutical interventions, dialled up and down based on the severity of future waves of infection. A Productivity Super-Boom Is Coming Periodic non-pharmaceutical interventions which include restrictions to national and international movement will be around for much longer than the general public and financial markets expect. This will solidify a more remote way of working, shopping, interacting, and doing business. The good news is that this will create the mother of all productivity booms. Productivity tends to surge after every recession. This is because the period immediately after a recession is when the economy experiences the most intensive clearing out of dead wood, restructuring of capital and labour, and absorption of new technologies and ways of working. The pandemic has forced nearly every company and every worker to adopt new technologies and ways of working and living. But whereas most recessions upend one or two sectors of the economy, the pandemic has upended all sectors – forcing nearly every company and every worker to adopt new technologies and ways of working and living. This will make the pandemic productivity boom a super-boom unlike anything experienced in recent history (Chart I-3). Chart I-3The Pandemic Productivity Boom Will Be A Super-Boom Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade The unfortunate corollary of this productivity super-boom is that the pace of absorption of the excess unemployed and inactive will be slower, meaning that it will take a long time to reach the goal of ‘full employment’ (Chart I-4). Chart I-4It Will Take A Long Time To Reach 'Full Employment' Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade In the US, the Federal Reserve is acutely aware of this. As Jay Powell has pointed out: “It’s going to be a different economy. We’ve been hearing a lot from companies looking at deploying better technology and perhaps fewer people, including in some of the services industries that have been employing a lot of people. It seems quite likely that a number of the people who had those service sector jobs will struggle to find the same job, and may need time to find work” Without full employment, it will be difficult to maintain US inflation at or above the Fed’s 2 percent target. The transmission mechanism is that the (permanent) unemployment rate establishes the ability to pay rent. Thereby, it is the main driver of ‘rent of shelter’, which comprises almost half of the core consumer price index. Empirically, unless rent of shelter inflation gets to 3 percent and remains there, it will be very difficult for core inflation to remain at over 2 percent (Chart I-5 and Chart I-6). For reference, rent of shelter inflation is now running well short of 3 percent, at 2.2 percent. Chart I-5Full Employment Is Needed To Lift Rent Inflation To 3 Percent... Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart I-6...And Rent Inflation At 3 Percent Is Needed To Keep Core Inflation At 2 Percent Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade In a nutshell, the coming years will be defined by a trifecta of surging productivity, massive slack in the labour market, and ultra-low inflation. Overweight Growth, And Overweight The US Given that new variants of the virus will create new waves of infection, that The Inflation Bubble Will Burst, and that the massive slack in the labour market will keep inflation structurally subdued, investors should own US T-bonds both tactically and structurally. There is massive slack in the US labour market. Furthermore, The Pareto Principle Of Investment tells us that if you get the direction of the bond yield right, you will get your whole investment strategy right. Declining bond yields boost growth stocks. This is because the ‘net present value’ of cashflows that are weighted deep into the future are highly leveraged to a falling discount rate. In addition, the productivity super-boom will be facilitated by technology and new economy sectors. As such, equity investors should avoid value, and steer towards growth, both tactically and structurally (Chart I-7). This extends to overweighting defensives versus cyclicals, overweighting the growth-heavy US versus the value-heavy euro area, and so on. In effect, all these positions are just one massive correlated trade (Charts I-8-Chart I-11). Chart I-7Structurally Overweight Growth Versus Value Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart I-8Correlated Trades: Bond Price, Growth Versus Value... Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart I-9...Tech Versus ##br##Market... Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart I-10...Defensive Versus Cyclical... Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart I-11...And US Versus Euro Area Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade These sector preferences also imply an overweight to developed markets (DM) versus emerging markets (EM). Tactically Underweight US REITS, And Tactically Overweight Nike Versus L’Oréal Finally, and corroborating the preceding sections, the rally in ‘reopening plays’ has become fractally fragile. One way to play this tactically is to underweight US REITS (Chart I-12). Chart I-12'Reopening Plays' Are Fractally Fragile: US REITS Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade But our preferred tactical expression is to overweight Nike versus L’Oréal (Chart I-13), setting the profit target and symmetrical stop-loss at 9 percent. Chart I-13'Reopening Plays' Are Fractally Fragile: L'Oreal Versus Nike Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Journal of Immunology Research, Volume 218: Immune Responses to RNA Viruses, by Elias A. Said Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart II-3Indicators To Watch - Bond Yields - Asia Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart II-4Indicators To Watch - Bond Yields - Other Developed Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart II-6Indicators To Watch - Interest Rate Expectations Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart II-7Indicators To Watch - Interest Rate Expectations Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade Chart II-8Indicators To Watch - Interest Rate Expectations Viral Variants Strike Down The Reflation Trade Viral Variants Strike Down The Reflation Trade  

Copper Shortage: Bids Gone Missing? Copper Shortage: Bids Gone Missing? The media went on a hype spree last month forecasting copper prices to the tune of $20,000t ($9.07/lb) on the back of EV-driven demand and supply shortages. While they will likely be right at some point over the next 10 years, such bullishness reminded us of the Goldman Sachs’ $200/bbl crude oil forecast back in May of 2008, followed by Gazprom’s $250/bbl number in June of 2008. By February 2009 crude was trading at $30/bbl. Given this anecdotal evidence and our view about the Chinese economic slowdown, on June 1 we recommended investors to buy crude at the expense of copper (proxied by long S&P oil & gas exploration & production / short S&P metals & mining indexes) as a way to capitalize on the DM/China growth differential. Since then, at the time of writing, the crude/copper ratio is up 17%, while our sector-level proxy is up 18.5%. Bottom Line: We reiterate our long S&P oil & gas exploration & production / short S&P metals & mining market neutral trade. For the full rationale behind this trade, please refer to the following Special Report.  

Overweight (High-Conviction) We remain overweight the S&P real estate index both in our cyclical and high-conviction universes, and both positions are currently up 7% since inception. While our initial rationale for putting the trade on was the flip in the correlation between this relative share price ratio and the 10-year US Treasury yield from negative to positive, now there are new catalysts that underpin this GICS1 sector. First, real assets have historically been a good inflation hedge making the S&P real estate index a popular addition to one’s portfolio in the current inflationary regime. Second, given that the market expects some turbulence thanks to the global growth slowdown, investors are adding real estate holdings as a defensive play (Chart 2). Finally, Chart 1 bottom panel shows that the supply-side of the equation is constrained as US commercial construction spending has been lagging. The implication is that in relative terms, the supply of commercial REITs has been contracting, pushing prices higher (relative construction spending shown inverted).  Tack on the anecdotes that empty offices are converted into apartment buildings, and empty malls into e-commerce fulfillment centers, and there is plenty of room for growth and improvement in the industry. Bottom Line: We reiterate our cyclical and high-conviction S&P real estate overweight calls. Chart 1 Revisiting Real Estate Revisiting Real Estate Chart 2 Revisiting Real Estate Revisiting Real Estate