Sectors

Highlights Fiscal stimulus is no longer a free lunch. US mortgage applications are down by 20 percent since the start of February. With rising bond yields now starting to choke private sector borrowing, bond yields are nearing an upper-limit, and even a reversal point. In which case, the tide out of defensives into cyclicals, and growth into value, will be a tide that reverses. New 6-month recommendation: underweight US banks (XLF) versus consumer staples (XLP). Fractal trade shortlist: US banks, bitcoin, ether, and GBP/JPY. Feature Chart of the WeekMortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Why would anybody not get excited about trillions of dollars of fiscal stimulus? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield, it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending has crowded out a dollar of private sector spending. In this case, fiscal stimulus will have no impact on GDP. The fiscal multiplier will be zero. Under some circumstances though, fiscal stimulus does not crowd out the private sector and the fiscal multiplier is extremely high. 2020 was the perfect case in point. As the pandemic gripped the world, much of the private sector was on its knees. Or to be more precise, in lockdown at home, doing nothing, receiving no income, and unwilling and unable to borrow. In such a crisis, the government became the ‘borrower of last resort’. It could, and had to, borrow at will to replace the private sector’s lost income and thereby to stabilise the collapse in demand. With no competition from private sector borrowers for the glut of excess savings, bond yields stayed depressed. Meaning that fiscal stimulus was a free lunch: it had lots of benefit with little cost (Chart I-2). Chart I-2Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Is No Longer A Free Lunch Covid-19 is still with us, and could be with us forever. Yet the economy will adapt and even thrive with structural changes, such as decentralisation, hybrid office/home working, a shift to online shopping, and less international travel. In fact, all these structural changes were underway long before Covid-19. Meaning that the pandemic was the accelerant rather than the cause of what was happening to the economy anyway. As the private sector now gets back on its feet to restructure, spend, and invest accordingly, fiscal stimulus is no longer a free lunch. Fiscal stimulus is most effective when it is not pushing up the bond yield. To repeat, last year’s massive fiscal stimulus was highly effective because it had little impact on the bond yield, so there was no crowding out of private sector borrowing. The markets have fully priced the 2021 stimulus, but not the crowding out. However, the most recent stimulus package has pushed up the bond yield or, at least, is a major culprit for the recent spike in yields. Hence, there will be some crowding out of private sector borrowing. Worryingly, US mortgage applications, for both purchasing and refinancing, are down by 20 percent since the start of February (Chart of the Week and Chart I-3). Chart I-3Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent The resulting choke on private sector borrowing and investment will at least partly negate any putative boost from this fiscal stimulus. The concern is that the markets have fully priced the stimulus, but not the crowding out. Time To Rotate Back In our February 18 report, The Rational Bubble Is Turning Irrational, we warned that high-flying tech stocks were at a point of vulnerability. Specifically, since 2009, the technology sector earnings yield had always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of a ‘rational bubble.’ In February, this envelope was breached, indicating that tech stock valuations were in a new and irrational phase (Chart I-4). Chart I-4The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The warning proved to be prescient. In the second half of February, tech stocks did sell off sharply and entered a technical correction.1 As a result, tech-dominated stock markets such as China and the Netherlands also suffered sharp declines. Proving once again that regional and country stock market performance is nothing more than an extension of sector performance (Chart I-5). Chart I-5As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets But the aggregate stock market has remained more resilient than we expected, and is only modestly down versus its mid-February peak. The reason is that while highly-valued growth stocks suffered the anticipated correction, value stocks continued to advance (Chart I-6). Chart I-6Time To Rotate Back Time To Rotate Back Time To Rotate Back We can explain this divergence in terms of the three components of stock market valuation: The bond yield. The additional return or ‘risk premium’ for owning stocks. The expected growth of earnings. Tech and other growth stocks are ‘long-duration’ assets meaning that their earnings are weighted into the distant future. Hence, for growth stocks the relevant valuation comparison is a long-duration bond yield, say the 10-year yield. Whereas for ‘shorter-duration’ value stocks the relevant valuation comparison is a shorter-duration bond yield, say the 2-year yield. Given that the 10-year yield has risen much more than the 2-year yield, the pain has been much more pronounced for growth stock valuations. Turning to the ‘risk premium’ for owning stocks, at ultra-low bond yields the risk premium just moves in tandem with the bond yield. Hence, as the 10-year yield has spiked, the combination of a rising yield plus a rising risk premium has doubled the pain for growth stock valuations. For a detailed explanation of this dynamic please see our February 18 report. Regarding the expected growth of earnings, the market believes that stimulus is much more beneficial for economically sensitive value stocks than for economically insensitive growth stocks. But now that we are at the point where rising bond yields are starting to choke private demand, the rise in bond yields is nearing a limit, and even a reversal point. In which case, the strong tide out of defensives into cyclicals will also be a tide that reverses. On this basis, and supported by the strong technical arguments in the next section, we are opening a new 6-month position: Underweight US banks versus US consumer staples, expressed as underweight XLF versus XLP. US Banks, Bitcoin, Ether, And The Pound This week we have identified susceptibilities to countertrend moves in three areas. The bullish groupthink in US banks is at an extreme. First, based on its fragile fractal structure, the (bullish) groupthink in US banks versus consumer staples is at an extreme approaching February 2016 (bearish), December 2016 (bullish), and March 2020 (bearish). All these previous extremes in fragility proved to be turning points in relative performance. If this proves true again, the next six months could see a reversal of US bank outperformance (Chart I-7). Chart I-7The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme Second, we are extremely bullish on the structural prospects for cryptocurrencies, and are preparing a report detailing the compelling investment case. Look out for it. That said, the composite fractal structures of both bitcoin and ethereum indicate that they are technically very overbought (Chart I-8 and Chart I-9). Accordingly, we are hoping for pullbacks that provide better strategic entry points for bitcoin at $40,000, and for ethereum at $1300. Chart I-8Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Chart I-9Ethereum Is Technically Overbought Ethereum Is Technically Overbought Ethereum Is Technically Overbought Third, the UK’s Covid-19 vaccination program was one of the fastest out of the blocks. As the vaccination rate quickly rose to over half the adult population (based on at least one vaccination dose), the pound was a major beneficiary. But now, the UK vaccination program is facing the hurdle of reduced supplies. Additionally, there is the danger that the third wave of infections in Continental Europe washes onto the shores of Britain. Hence, the recent strong rally in the pound is susceptible to a countertrend reversal (Chart 10). This week’s recommended trade is short GBP/JPY setting the profit target and symmetrical stop-loss at 2.2 percent. Chart I-10The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 A technical correction is defined as a 10 percent price decline. Fractal Trading System Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Asset Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Equity Market Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​​​

Beware The Greenback's Coiled Spring Potential Beware The Greenback's Coiled Spring Potential The mighty USA remains the world’s growth locomotive that tugs the global economy higher. In fact, in a recent Strategy Report we highlighted how US growth expectations outpace the EMU (see Chart 17 here) by a hefty margin. Even the Fed has now thrown in the towel and expects 6.5% real GDP growth for calendar 2021. Such dominance also comes at a small cost as foreigners begin to accumulate US financial assets that, at the margin, drains US dollar-based liquidity. Similarly, chip and other shortages the world over along with transportation bottlenecks also slow down global trade that in turn further mops up USD liquidity. The knock-on effect of an appreciating US dollar is well-known: it effectively tightens global monetary conditions. In more detail, it deals a blow to emerging markets (EM) especially twin deficit countries, and also eats into 40% of SPX sales that are foreign sourced. As a reminder, we recently downgraded the cyclicals/defensives portfolio tilt from overweight to neutral in anticipation of EM-driven headwinds in general, and China’s looming slowdown in particular. Bottom Line: Near-term caution is warranted, and we reiterate our recent downside protection trigger, where our portfolio went long June VIX futures as a hedge.  

Highlights Biden has enough political capital to pass at least one more major piece of legislation. The next major bill will increase the budget deficit further, adding additional stimulus, though it will consist of structural reforms over a ten-year time frame and with a drag created by tax hikes. Our annual key views are on track: polarization has subsided but remains at peak levels from a historical point of view; structural reform is underway, although any chance of bipartisanship is slipping; the Republicans remain deeply divided despite some signs of regrouping. Investors should remain cyclically bullish although the sharp rise in bond yields, the bounce in the US dollar, China’s growth deceleration, and geopolitical risks all warrant tactical caution in the near term. Feature The first quarter of the year brought a few political surprises – from the Capitol Hill riot to Trump’s second impeachment – but the only significant surprise for the American investor was the Democratic victory in the Georgia Senate runoffs. This victory changed the policy setting, producing a Democratic majority in the US Senate and enabling the Biden administration to project three budget reconciliation bills (for FY2021, 2022, 2023) that require zero Republican votes.  The first of these bills was signed into law promptly as expected. The $1.9 trillion American Rescue Plan Act consists of short-term cash handouts and social spending that will supercharge an economic recovery that is rapidly accelerating due to the rollout of vaccines for COVID-19 (Chart 1). Chart 1American Rescue Plan Boosts GDP Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The second major piece of legislation, likely the budget reconciliation bill for FY2022, will consist of net increases to the budget deficit, thus further stimulating the economy, albeit along with structural reform, i.e. social safety net and tax hikes, and a 10-year time horizon. In the second quarter investors will learn the parameters of the bill through Biden’s address to a joint session of Congress, an idealistic presidential budget proposal, a more realistic House and Senate budget resolution, and an extended negotiation. Yet Biden’s second bill will probably not be signed into law until the third or even fourth quarter. Big Government Is Back The American Rescue Plan Act cements a new era of “Big Government” that should be ascribed not to any particular party but to underlying populist pressures in the United States. President Trump’s big-spending ways and pandemic relief packages had already produced a major step up in the government contribution to economic output, as shown in Chart 2, and this will go higher once Biden’s 8.7% of GDP bill is added to the mix. This increase in the government role is likely to last beyond the pandemic given that President Trump had already taught the Republicans that fiscal austerity does not win votes. Republicans will still be the party of “limited government” but that is a relative concept and they will not be able to win elections on a platform of slashing spending, at least not until stagflation returns. In the meantime they are out of power and tax-and-spend liberals rule the roost. Chart 2Era Of Big Government Is Back Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our updated budget projections show that the decline of stimulus spending will be gradual in the coming years if Biden delivers his second reconciliation bill for FY2022 (Chart 3). Major changes from previous versions have to do with changes to the Congressional Budget Office’s baseline outlook. Our new Democratic Low Spending scenario assumes a $2 trillion dollar green/infrastructure package, a $1 trillion health care reform, and a roughly $2 trillion increase in tax revenue. The Democrats will raise taxes – at least partially repealing Trump’s Tax Cut and Jobs Act and raising a few other taxes. We expect the market to be negatively surprised by the magnitude of tax hikes, at least initially, though the upside risk to the equity market is that tax hikes will be watered down by moderate Democrats in the Senate. We would not bet on a positive tax surprise because even moderate Democrats are in favor of taxing corporations and the wealthy, the taxes can be phased in over a 10-year period, and the economy is on a cyclical upswing combined with mammoth new spending programs. Chart 3US Budget Deficit Booms Under Biden Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our presumption that Biden will sign his second major bill into law this fall (even as late as December) rests on the vulnerability of his administration and party. Traditional Democrats, embodied by Biden, Democratic leaders in Congress, and Biden’s technocratic cabinet (Appendix), face a historic accumulation of political pressure from their populist left-wing and from Trump’s populist Republican Party. If they cannot deliver on major “bread and butter” promises to the American people, while including just enough progressive elements to keep the far left at bay, they risk extinction in coming election cycles. This pressure is real and will enable at least one more major legislative achievement. Bottom Line: Government spending has taken a big step up and Biden’s second major legislative initiative will ensure that the step up is permanent rather than a temporary response to a crisis. The macro impact is inflationary on the margin. Biden’s Second Reconciliation Bill Is the Biden administration over-stimulating the economy and setting the US up for overheating? It looks like it, though the size of tax hikes is as yet unknown. Going forward the stock market will be extremely attentive to two risks that cut in different directions: excessive stimulus and excessive tax hikes. The American Rescue Plan alone is more than twice as large as the estimated output gap. The output gap is widely expected to be closed by the end of the year (Chart 4). Even a $1 trillion infrastructure package – much lower than the currently rumored $3 trillion – would be excessive in this context. Chart 4Output Gap Is Virtually Closed Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The infrastructure package that is being planned – which would include a range of measures in addition to roads and bridges, such as green energy projects, supply chain on-shoring, and digital infrastructure – would take place over a ten-year period and will be coupled with a drag from new taxes. A modern-age infrastructure plan would boost productivity and hence potential GDP growth, which could offset some of the inflationary impact. Speculatively, the simplest path for achieving Biden’s objectives would be to put his health care reform (with other welfare proposals) in the FY2022 reconciliation bill along with tax reform. Tax changes are the purpose of the reconciliation process. Unlike infrastructure, health provisions are virtually guaranteed to pass the arcane rules of reconciliation. This is not a minor concern: the Senate parliamentarian ruled out a federal minimum wage hike in the American Rescue Plan because it was not directly germane to government revenues and expenditures and could do the same to infrastructure. Bear in mind that the Obama administration passed a key component of the Affordable Care Act (Obamacare) via reconciliation, setting a precedent that health care is germane. More broadly the Democratic Party has prioritized health care since 1992, now has a chance to clinch it, and has repeatedly benefited at the ballot box on the health agenda. Infrastructure, unlike health and tax reform, could conceivably pass in a regular bill, or piecemeal in annual spending bills, in which Biden would wheel and deal to try to get 60 votes (50 Democrats, 10 Republicans). However, the latest rumors as we go to press suggest the Democrats will prioritize infrastructure and link it to tax reform. Republicans will not vote for tax hikes so reconciliation would still be required in this case. Reconciliation is trickier with infrastructure spending than with health care, though not impossible. What is clear is that Biden’s agenda is too large to fit into one bill, that tax hikes are being planned, and that reconciliation is necessary for tax hikes. Based on our scenarios in Table 1, every realistic scenario involves an increase to the budget deficit, ranging from around $500 billion to $5.4 trillion over the 10-year period. Therefore the economy will receive additional stimulus on top of the unprecedented peacetime stimulus it has already received. Table 1Scenarios For Biden’s Second Reconciliation Bill Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Two other gleanings from Q1 bear mentioning: Biden’s policies on trade and immigration. On trade, Biden is coopting Trump’s hawkish China policy while trying to improve trade relations with allies and partners. The trade deficit is set to expand along with economic recovery and stimulus, resulting in larger twin deficits (Chart 5). This trend should weigh on the US dollar – but the dollar has strengthened so far this year. Given the US’s inherent strengths – rule of law, innovation, faster relative growth – and the structural rise in global geopolitical tensions, covered regularly by our twin Geopolitical Strategy, we are loathe to bet against a rising dollar. However, investors should note that the BCA House View expects the dollar to relapse and the dollar bear market to continue. On immigration, Biden faces his greatest domestic policy challenge. By easing border and immigration enforcement amid a hyper-charged economic recovery, he has invited a large flow of immigrants and refugees (Chart 6). He is thus forced to take urgent border actions to staunch the flow. If he does what is necessary to maintain order then he will widen the rift with the far left. Meanwhile Republicans are finding an issue over which they can start to reunite. Chart 5US Twin Deficits Balloon US Twin Deficits Balloon US Twin Deficits Balloon Chart 6Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Bottom Line: The air of crisis is dissipating rapidly and proposed tax hikes will motivate opposition but Biden still has enough political capital to get at least one more budget reconciliation bill passed. The bill will focus on health/welfare (easier to pass but more inflationary) or infrastructure (harder but better for productivity). Either way the net deficit impact will be negative and the dual risk of higher taxes and economic overheating will create hurdles for the stock market rally.   Updating Our Three Key Views For 2021 How do the events of Q1 impact our three key views for 2021? At the start of the year we forecast (1) that the US’s political polarization would subside but remain at historically peak levels; (2) that the US would launch major structural reforms, in some cases on a bipartisan basis; (3) that Republican disunity would enable this contradictory environment of polarization yet occasional bipartisanship. Based on the first quarter’s events, we would draw the following conclusions for the second quarter and beyond: 1.   Peak Polarization: Polarization has indeed subsided (Chart 7). The country is still vulnerable to major polarizing events, including domestic extremists of whatever stripe, though any major terrorist attack would likely strengthen support for the sitting government. A fall in polarization is just one positive factor in Biden’s overall political capital, which we measure through our US Political Capital Index (Table 2). We consider Biden’s political capital moderate-to-strong because consumer confidence and the economy will likely improve. However, passing legislation will gradually get harder. The Obama administration had considerably greater strength in the Senate than the Biden administration, though, as mentioned, reconciliation guarantees Biden one or two more major pieces of legislation (Chart 8). Democrats can still overturn the filibuster, which requires a 60-vote majority on regular legislation, as we have long highlighted. But for now they seem to accept a watering-down of the filibuster (a “talking filibuster”) that will still give the minority Republicans the ability to halt controversial legislation. Chart 7Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Table 2Biden’s Political Capital Is Moderate To Strong Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Chart 8Major Legislation Can Pass Early In Presidential Term Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform 2.   Bipartisan Structural Reform: The fact that not a single Republican senator voted for the American Rescue Plan Act, despite the lingering pandemic and air of crisis, suggests that bipartisanship is extremely limited, e.g. limited to the seven Republican senators who voted to convict Trump (Table 3). However, bipartisanship is still possible on an infrastructure package if the Democrats do not link it with tax hikes. Table 3Centrist Senators – And Republicans Who Voted To Convict Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Beneath the surface there is bipartisanship when it comes to trade, supply chains, and countering China. Tariffs bottomed under the Obama administration and Biden started off with another round of “Buy America” provisions and a tentative decision to maintain Trump’s tariffs on China (Chart 9). Measures to boost US supply chain resilience in technology, health, and defense could be rolled up into an infrastructure package to help garner 10 Republican votes. Republicans have prepared for possible compromise by clearing the way for the use of “earmarks,” or constituency-based legislative incentives, otherwise known as pork-barrel spending.  Chart 9Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama The market currently expects an infrastructure bill to pass, as indicated by the outperformance of infrastructure-related stocks, industrials, and materials relative to the market. Our BCA Infrastructure basket is outperforming (Chart 10). The market does not currently expect the Democrats to focus on health care policy, which creates the likelihood of a negative surprise for this sector (Chart 11). Chart 10Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) The managed health care sub-sector (the insurance companies) staged a surprise rally over the past month that should reverse as Biden’s legislative proposals become known. However, Big Pharma and biotech continue to sell off as expected. Again, the simplest FY2022 reconciliation bill would consist of Biden’s health reform plus tax reform. The market is having some doubts about Democrats’ climate change agenda, which will be stuffed into the infrastructure package, given that the US renewable energy index has rolled over relative to global renewables. US cyclicals are also outperforming renewables (Chart 12). If Democrats do not use reconciliation, they may not get many green projects passed. If they do use reconciliation, their health and welfare reforms will have to wait until a FY2023 reconciliation bill that may not get passed. Chart 11More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma Chart 12Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage   3.   Republicans In The Wilderness: Although Republicans have begun to regroup faster than many expected, the divisions within the party have not been healed and will continue to flare up in disputes that threaten to wreck the party. Trump and the populist wing are preparing to put up primary election challengers to establishment Republican senators and representatives who voted against Trump or otherwise who vote against his “America First” agenda. Yet it is possible that 10 Republicans will find it impossible to vote against Biden’s infrastructure package if it is well-designed regarding supply chains and China and not linked with tax hikes. Trump could split the party via his personal following (which may be enhanced by a new social media outlet) and his ability to divide the party’s votes if he forms a “Patriot Party.” We recently showed, via the “Prisoner’s Dilemma” in game theory, that the Republicans must choose a Trumpist agenda of fiscal largesse, trade protectionism, and border security if they are to succeed. Yet Trump may or may not choose to run for president again or form a third party. The result is that Trump is more likely than not to be the Republican candidate in 2024 but there are huge risks to the party’s coherence as the party establishment tries to convince Trump to bow out and support a successor (Diagram 1). The point is that Trump remains a loose cannon and is capable of dividing the party single-handedly. Since investors cannot predict Trump’s behavior they should not expect the Republicans to unite in the near term. Diagram 1Game Theory Says Republicans Will Court Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Bottom Line: Our three key views for 2021 are broadly on track – polarization is subsiding but still near peak levels, structural reform is underway (though bipartisanship is clearly at risk), and the Republicans remain divided and ineffectual. The Democrats’ handling of their infrastructure package will determine if bipartisanship can reinforce structural reform but the FY2022 reconciliation process enables them to achieve some reform regardless. Investment Takeaways The Federal Reserve expects GDP to grow by 6.5% in 2021 as a whole (up from the 4.2% estimate in December) and the unemployment rate to fall to 4.5% by the end of the year (down from 5% previously). Treasury Secretary Janet Yellen is expected to predict full employment by 2022. Households are likely to spend at least a third of the $699 billion in dole money they receive (stimulus checks and topped-up unemployment benefits), according to surveys highlighted by our Global Investment Strategy. This summer will have a party on every block, whether authorized or not. While details are scant about the exact makeup of the Biden administration’s next major legislation, what is clear is that it will have a net negative impact on the budget balance. Democrats will raise taxes but not so much as to jeopardize the economic recovery and their election prospects in 2022-24. This ultra-easy fiscal policy coincides with an ultra-easy monetary policy in which the Fed has insisted it will not raise rates through 2023. The market expects four rate hikes by that time, which would put the Fed funds rate at about 1.1%. The Fed will eventually have to adjust its path for the Fed funds rate and start thinking about thinking about tapering asset purchases. But the main thing to remember is that the Fed has committed to generating an inflation overshoot.   In this context, US investors should be cyclically bullish albeit tactically guarded given the sharp rise in bond yields and rising dollar. A pro-cyclical orientation would favor small caps over large caps, cyclicals over defensives, and value over growth stocks. All of these positions have recently met with some resistance and could face a healthy near-term correction. Cyclical stocks are historically very elevated relative to defensives (Chart 13). But over a 12-month period the recovery and stimulus will reinforce the bullish view, as rising bond yields will not stop equities from rising if the Fed stands pat. Chart 13Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives The chief risks to the pro-cyclical orientation stem from any breakout in the US dollar, the rollover in China’s growth momentum, and the Biden administration’s tax hikes and foreign policy challenges. These risks are all immediate and serious, especially given high stock market valuations. China’s policy tightening will not be fully felt in the economy until the second half of the year and Biden’s specific foreign policy challenges can result in negative geopolitical shocks at any time this year or over the next four years. The point is to buy on the dips unless surprise events fundamentally alter the reflationary cyclical backdrop. With regard to equity sectors, our US Political Risk Matrix highlights the chief policy risks to our US Equity Strategy’s views. Generally speaking Biden poses upside risks to industrials and consumer discretionary sectors and downside risks to energy, health care, tech, and communications (Table 4). After a quarter’s worth of information on markets and policy, these views are mostly confirmed: stay cyclically bullish on industrials and financials, bearish on tech and health care. Table 4US Political Risk Matrix Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform In the case of energy we continue to be neutral-to-bullish over a 12-month time horizon as long as demand is recovering, global inventories are drawing down, and the immediate geopolitical scene is conducive to tit-for-tat attacks in the Middle East, as is the case in the first half of the year. But Biden’s regulatory risks and disruptive climate change agenda can bring negative surprises for US oil producers and Biden’s foreign policy would ultimately be positive for Middle East oil supply. In the case of communications services we are neutral-to-bearish. The Biden administration is allied with Big Tech but it is tightening regulation and anti-trust enforcement gradually to gain greater control over the sector.1 The Treasury selloff is set to continue. Yields are starting to reach pre-COVID levels and have a way to go until they challenge 2018 levels. From peak to trough in the Bloomberg Barclays Treasury Index, the current selloff is not as bad as in the past four recoveries, as our US Bond Strategy has shown. As the economic rebound shows up in hard data over the course of this year, the Fed’s revised expectations will confirm the bond selloff in the financial market. We would thus favor high-yield corporate bonds. We remain overweight TIPS and municipal bonds relative to duration-matched nominal bonds. In recent years presidential approval has correlated remarkably well with the stock-to-bond ratio about two months later (Chart 14). The implication is that higher presidential approval is consistent with receding uncertainty and greater consumer optimism about the economy, which is reflected in rising bond yields and share prices. Neither Biden’s approval rating nor the stock-to-bond ratio is likely to go much higher without a consolidation phase, however, as implied by the chart. Chart 14Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A1BPolitical Capital: Household And Business Sentiment Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform   Table A1CPolitical Capital: The Economy And Markets Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A2Biden’s Cabinet Position Appointments Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Footnotes 1     Biden is expected to nominate anti-trust scholar Lina Khan for FTC commissioner.  

Reinstating Long VIX Futures Hedge Reinstating Long VIX Futures Hedge Last December in our “2021 High-Conviction Calls” Strategy Report we instituted a long VIX futures trade (for a second time) as a hedge to our cyclical exposure, and earlier this year we crystallized handsome gains just shy of 20% from this hedge. Subsequently, we put on a stop buy order at 25 on the June 2021 VIX futures and that was triggered intraday on Monday. We are obeying our stop buy and have reinstated our hedge. Over the past month, we highlighted how Chinese data softening (see here and here), coupled with the lack of an SPX valuation cushion could spell some short-term trouble for the broad equity market. The chart on the right further underpins the point: the VIX’s term structure indicates that stress has built up beneath the surface. Tack on the fact that the SPX sits near our end-2021 4,000 target, and short-term cautiousness is warranted anew. Bottom Line: Intraday on Monday we obeyed our stop buy order and initiated a long June 2021 VIX futures position at 25 as a near-term hedge to our high-conviction calls. ​​​​​​​

Today marks the one year anniversary of last year’s SPX lows and we are compelled to reprint the “20 Reasons To Buy Equities” part of our report that Monday “as is” that was titled “The Darkest Hour Is Just Before The Dawn”. The appendix below shows the updates to the charts, and as we reflect how far the stock market expansion has come in the past year, this unique recovery remains quite astounding and with no close historical parallel. Bottom Line: While the SPX is getting close to our 4,000 yearend target and some near-term caution is warranted the equity bull market (and business cycle) is in its infancy and we reiterate our cyclical and structural sanguine views. 20 Reasons To Buy Equities Below are the 20 reasons to start buying equities. We are already in recession. Markets trough in recessions and historically offer enticing risk/reward return profiles. China’s manufacturing PMI and other hard data fell below the GFC lows. As a general rule of thumb investors should buy stocks when the global PMI is well below 50 (Chart 1). Cupboards are bare. A drawdown in inventories is usually followed by a jump in production. Consumers will benefit from the oil market carnage and the super low mortgage refinancing rates. The Fed cut rates to zero, did QE5, and brought back the alphabet soup of programs like CPFF, PDCF and MMLF from the GFC, more will likely follow (Chart 2).  The DXY has gone from 95 on March 9 to 103 on Friday. King dollar will soon have to reverse course and provide some much-needed relief globally as the Fed’s US dollar swap lines aim to alleviate the shortage of US dollars (Chart 3). Keep in mind what Dr. Bernanke told Scott Pelley in a 60 Minutes interview with regard to money creation: “PELLEY: Is that tax money that the Fed is spending?   Chart 1 Chart 1 Chart 2 Chart 2 BERNANKE: It's not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed (emphasis ours). So it's much more akin to printing money than it is to borrowing.”1     Chart 3 Chart 3 Chart 4 Chart 4 Other global Central Banks are cutting rates and doing QE. Beyond Christine Lagarde’s recent €750bn bazooka, the ECB has the OMT ready from previous crises. Already last week the ECB intervened in Italian BTPs via Banca d’Italia. Germany has hinted that it would not be opposed to a “Covid-bond.” A mega US fiscal package looms near the $1tn mark.2 The recession-related automatic stabilizers and government spending will soar. China’s fiscal response will likely be as large as in late 2008 (as a reminder in Q4/2008 the Chinese fiscal spending announcement equated “to 12.5% of China’s GDP in 2008, to be spent over 27 months”3). Germany and a slew of other countries have already pledged fiscal spending. Spain has announced a 20% of GDP package. Countries will bid-up the size of the bailout. IMF announced a $1tn bailout package. Nibbling at stocks when the VIX is at 85 makes sense versus when the VIX is at 12 (Chart 4). The yield curve slope is steepening  (Chart 5). The 10-year real Treasury yield hit a low of -50bps that indicator has also priced in recession (Chart 4). Equity market internals have fully priced recession, small caps and weak balance sheet stocks in particular (Chart 6). Sentiment is washed out as per our Capitulation, Sentiment and Complacency-Anxiety Indicators (Chart 6). Bernie Sanders has lost his bid to become the nominee of the Democratic Party. Buffett will either bailout a company or two or buyout a company he likes. Jamie Dimon and/or other prominent CEOs (insiders) will start buying their own company stock. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a break-through in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus. Bottom Line: Investors with higher risk tolerance should continue to layer in slowly and put cash to work with a cyclical 9-12 month time horizon. Please refer to yesterday’s Weekly Report for more details.     Chart 5 Chart 5 Chart 6 Chart 6   Appendix Chart A1 Chart 1 Chart 1 Chart A2 Chart 2 Chart 2 Chart A3 Chart 3 Chart 3 Chart A4 Chart 4 Chart 4 Chart A5 Chart 5 Chart 5 Chart A6 Chart 6 Chart 6 Footnotes 1 https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 2 Please see BCA US Equity Strategy Daily Report, "Don’t Be A Hero" dated March 11, 2020, available at uses.bcaresearch.com. 3 https://www.oecd.org/gov/budgeting/Public%20Governance%20Issues%20in%20China.pdf  

Highlights Portfolio Strategy China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Recent Changes Lock in gains of 4.3% and downgrade the S&P construction machinery & heavy trucks index to neutral, today. Table 1 Pricing Power Update Pricing Power Update ​​​​​​​ Feature While the Fed’s dots dovishly surprised market participants last week, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s 2021 core PCE price inflation estimate to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. Clearly, the Fed is in a bind as it tries to strike a delicate balance between short and long term rates. Our thesis, first posited on February 1, remains that the bond market will keep on testing the Fed’s resolve until the FOMC members start to “talk about talking about tapering”. An economy running on steroids buoyed both by ultra loose monetary and fiscal policies at a time when it is primed to reopen at full speed around Memorial Day is inherently inflationary. Under such a backdrop, the subsurface equity market’s response makes perfect sense. “Back-To-Work” stocks left “COVID-19 Winners” in the dust, small caps outperformed the Nasdaq 100, the Value Line Arithmetic Index and the RVRS1 exchange traded fund outshone the SPX and the S&P 495 trounced the S&P 5 (Chart 1). In other words, when growth is scarce as during last year’s recession investors flock to growth stocks, now that growth is abundant investors are cornering value stocks with the highest degree of operating leverage (top panel, Chart 1). While this deck reshuffling may go on temporary hiatus as the 10-year US Treasury yield pauses for breath, this sector rotation has cyclical staying power. Given this looming inflationary impulse context, today we update our Corporate Pricing Power Indicator (CPPI). Chart 2 shows that our CPPI has swung over 10 percentage points from the recent trough, accelerating north of 5%/annum pace. In fact, our diffusion index of the 60 selling price categories we track has vaulted to all-time highs (second panel, Chart 2). Chart 1Anatomy Of The Market Anatomy Of The Market Anatomy Of The Market Chart 2Corporate Pricing Power Flexing Its Muscles Corporate Pricing Power Flexing Its Muscles Corporate Pricing Power Flexing Its Muscles Wage inflation is also coming out of hibernation, with job switchers outpacing job stayers’ salary inflation, according to the latest Atlanta Fed wage growth trackers (third panel, Chart 2). Importantly, the most recent NFIB survey showed that small businesses have the hardest time filling job openings by finding qualified labor. Over the past three decades, this backdrop has been conducive to wage inflation (Chart 3), and if history at least rhymes, a pick-up in wage inflation is in the cards in the back half of the year (Chart 4). Our sense is that the economic reopening will by then be at full speed, further exacerbating wage pressures. Chart 3Inflation… Inflation… Inflation… While profit margins are on the cusp of shaking off the remnants of the COVID-19 accelerated recession, sell-side analysts’ 12-month forward profit margin estimates show no signs of input cost pressures, at least not yet. The risk is that corporations may find it challenging to pass on these looming wage increases down the supply chain and all the way to the consumer in order to preserve margins (bottom panel, Chart 2). The jury is still out on who will eventually have to bear the brunt of inflationary pressures, especially in the context of rising fiscal deficits (i.e. personal current transfers). Drilling beneath the surface, our CPPI signals that genuine inflationary pressures are mounting as supply chains are strained causing shortages on a slew of manufacturing industries. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 4…Is Coming …Is Coming …Is Coming Table 2Industry Group Pricing Power Pricing Power Update Pricing Power Update While 68% of the industries we cover are outright lifting selling prices, half are doing so at a faster clip than overall inflation. With regard to pricing power trends, encouragingly only 30% of the industries we cover are in a downtrend (Table 2). Services industries mostly populate the bottom half of Table 2 with the usual suspects – airlines, air freight, hotels and movies & entertainment – that COVID-19 wreaked the most havoc to occupying the bottom four spots. Nevertheless, this is looking in the rearview mirror. The tide is slowly turning as a recent update from the TSA highlighted that passenger enplanements are perking up. Lumber has reached escape velocity and has sustained forest products atop our table with a meteoric year-over-year growth rate of 149%! Commodities populate nine out of the top ten spots and while gold has fallen down the ranks since our last update, it is still expanding at a near 10%/annum rate, despite the greenback’s year-to-date rise. Energy related commodities are on fire and peak oil inflation will hit in April/May due to base effects. Keep in mind that last spring WTI crude oil prices sank into a deeply negative print per bbl. While at first sight all seems upbeat in the commodity complex, beneath the surface some cracks are forming. This week, we revisit our number one macro risk for the back half of the year: China’s pending slowdown, and downgrade a deep cyclical capital goods sub-group to neutral. Gauging China’s Slowdown Cresting in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel, Chart 5), and now we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel, Chart 5), and the near-term risk is that the S&P 500 may be next in line (top panel, Chart 5), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Taking cue from Chinese financial market data is also instructive. The MSCI China stock price index, its short-term momentum, net EPS revisions and 12-month forward EPS growth all troughed last spring. It is slightly unnerving that by all these metrics China’s stock market recovery is coming off the boil and may be a precursor to a soft-patch in the coming months (Chart 6). Chart 5Monitor China Closely Monitor China Closely Monitor China Closely Chart 6What Are Chinese Stocks Sniffing Out? What Are Chinese Stocks Sniffing Out? What Are Chinese Stocks Sniffing Out? Importantly, select commodities, especially ones that are hypersensitive to Chinese activity, appear exhausted and have likely hit, at least a temporary, zenith. While anecdotes of metal related scams and thefts are mushrooming especially catalytic converters mostly owing to rare earths soaring prices, we would not be surprised were bronze/copper statues to start disappearing and sold for scrap, as was prevalent in the mid-2000s commodity super cycle. Dr. Copper has more than doubled in the past year, is near all-time highs and already discounts a lot of good China recovery news (top panel, Chart 7). Historically, Google Trends searches for “commodity super cycle” have been closely correlated with cyclicals/defensives relative performance and the recent spike near all-time highs likely corroborates that the Chinese recovery is well advanced (Chart 8). Chart 7Glass Ceiling Glass Ceiling Glass Ceiling Chart 8“Commodity Super Cycle” Hubris? “Commodity Super Cycle” Hubris? “Commodity Super Cycle” Hubris? WTI crude oil prices have also jumped over $100/bbl after hitting the negative $37/bbl mark last April. In the mid-60s/bbl crude oil has likely hit a ceiling and will have a tough time surging past this long term resistance. Sentiment is as extreme as it was during the Desert Storm in the early 1990s, which is the last time the oil RSI jumped over 80 (Chart 9)! Chart 9Slippery Slope? Slippery Slope? Slippery Slope? The Australian dollar, a commodity currency levered to China’s wellbeing, has also been on a tear since last March with AUDUSD rising from 0.55 to roughly 0.80. The Aussie is currently at the upper band of its range, since the Hawke/Keating government floated it in 1983, and facing stiff resistance. There are rising odds that AUDUSD is also sniffing out some China softness in the coming months (bottom panel, Chart 7). Finally, Chinese surveys and money aggregates data also signal that a garden variety slowdown will take root, especially post the 100-year Communist Party anniversary this summer. The Chinese manufacturing PMI is awfully close to the 50 expansion/contraction line, at a time when both M1 money supply has ticked lower and the total social financing impulse has rolled over (Chart 10). Tack on our sister’s China Investment Strategy’s recent estimate of a further steep deceleration in the latter and factors are falling into place for an engineered slowdown in China in the back half of the year (bottom panel, Chart 10). Bottom Line: China is on the cusp of a slowdown, remains a key macro risk to monitor, and thus we use this opportunity to book gains in a deep cyclical industrials sub-group and downgrade to neutral. Chart 10Keep Your China Guard Up Keep Your China Guard Up Keep Your China Guard Up CAT Stalling? As China’s economic growth downshifts, we are compelled to book gains in machinery stocks and downgrade to neutral. This sub-surface industrials sector move comes on the heels of last week’s upgrade in the more domestically focused railroads, and does not affect the broad sector’s overweight stance. First, machinery stocks are extremely overbought by historical standards outpacing the SPX by 36% on a year-over-year basis. Valuations have also spiked: the relative price to sales ratio is back near par and trades at a 25% premium to the historical average (Chart 11). Such lopsided positioning is fraught with danger and could at least temporarily reverse in a violent fashion. Second, while the US dollar has been boosting the industry’s exports and adding to machinery P&L via positive translation gains, the greenback’s year-to-date appreciation will eat into profits, at the margin, in the back half of the year (second & middle panels, Chart 12). Chart 11Too Far Too Fast Too Far Too Fast Too Far Too Fast Chart 12First Signs Of Cracks Appearing First Signs Of Cracks Appearing First Signs Of Cracks Appearing Sell-side analysts have taken notice and net profit revisions have topped out. Similarly, our EPS growth macro models suggest that machinery stocks will struggle to outearn the SPX (Chart 12). Lastly, as China goes, so go machinery stocks. The latest Chinese manufacturing PMIs hooked down and any sustained weakness will weigh heavily on demand for US machinery new orders (fourth panel, Chart 12). Tack on the waning impulse of Chinese total social financing aggregates including BCA’s downbeat forecast, and the outlook for machinery end-demand darkens further (Chart 13). Nevertheless, before getting outright bearish on machinery stocks, there are a few offsetting factors. Commodity prices, while toppy, remain firm, and alleviate fears of a severe Chinese slowdown. Moreover, Chinese excavator sales are on a tear surging to a three year high. While China’s manufacturing PMI has petered out, both the global PMI and developed market PMIs are reaccelerating. As the global economy reopens, services PMIs will further boost the global composite PMIs (second & bottom panels, Chart 14). Chart 13Chart Of The Year Candidate Chart Of The Year Candidate Chart Of The Year Candidate Finally, while our relative EPS growth models hover near the zero line, the same is also true for the sell side’s profit growth estimates and represent a modest hurdle for the industry to surpass (third panel, Chart 14). Netting it all out, China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Chart 14Reasons Not To Turn Outright Bearish Reasons Not To Turn Outright Bearish Reasons Not To Turn Outright Bearish Bottom Line: Downgrade the S&P construction machinery & heavy trucks index to neutral today for a relative gain of 4.3% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CSTF – CAT, CMI, PCAR & WAB.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     The Reverse Cap Weighted U.S. Large Cap ETF (Ticker: RVRS) provides exposure to the companies in the S&P 500 index. However, while traditional market cap weighted indexes such as the S&P 500 weight companies inside the index by their relative market capitalization, RVRS does the opposite, weighting companies by the inverse of their relative market cap. By investing smallest-to-biggest, the fund is tilting investment exposure to the smaller end of the market cap spectrum within the large cap space. https://exponentialetfs.com/wp-content/uploads/2021/01/Reverse-ETF-Factsheet_2020.12.311.pdf Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 ​​​​​​​Favor value over growth

While the Fed’s dots dovishly surprised, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s core PCE price inflation estimate for 2021 to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. The last time the US economy hit such a high mark on a q/q annualized basis (ex-2020) was in late-2003 (Chart 1). Back then the Bush tax cuts were signed into law in late May 2003 turbocharging the economy. Chart 2 shows that the fed funds rate was pegged at 1% and the bond market was in selloff mode, with both the 10-year US Treasury yields surging violently and inflation breakevens galloping higher. While the S&P eventually shrugged off the bond market’s new equilibrium yield, drilling beneath the surface is revealing. Chart 1 Shades Of 2003/4? Shades Of 2003/4? Chart 2 Shades Of 2003/4? Shades Of 2003/4? As a reminder, back then the Fed was actually sowing the seeds of the housing bubble by keeping rates at 1%, which resulted in an economy running on steroids. Deep cyclical sectors outperformed the SPX and defensives significantly lagged the broad market especially as the economic data caught on fire in 2004 (see Appendix Charts A1, A2, A3, ). Financials were range bound and relative tech performance slumped in 2004 (for inclusion purposes Charts A4-A9 in the Appendix also show GICS2 sector relative performance). Bottom Line: Using the 2003/4 parallel as a guidepost we remain comfortable with our current positioning of preferring industrials and energy to consumer staples and communication services. Appendix Chart A1 Appendix Appendix Chart A2 Appendix Appendix Chart A3 Appendix Appendix Chart A4 Appendix Appendix Chart A5 Appendix Appendix Chart A6 Appendix Appendix Chart A7 Appendix Appendix Chart A8 Appendix Appendix Chart A9 Appendix Appendix  

The pandemic-induced recession surely did hurt earnings, but it also served as a wakeup call to corporate executives as they scrambled to boost business efficiencies. The chart below is showing our proxy (using equally weighted industrials/materials/tech/health care/consumer staples and consumer discretionary) for the degree of operating leverage (DOL) for the broad US equity market. The current reading of just below 2 means that an additional 1% increase in sales translates into a nearly 2% increase in earnings. The fact that DOL has rebounded significantly over the past year from negative territory – where it spent the second half of 2019 likely due to capital misallocation brought by excessive share buybacks – also means that the transmission mechanism from top-to-bottom line growth has been unclogged as corporations cleared out the deadwood. Another message from the recovering US equity market DOL is that the current cycle is just getting started, which also supports our secular 2028 SPX 7000 target. Bottom Line: We remain cyclically and structurally bullish on the prospects of the broad equity market, but are keeping our guard up in the near-term. Unclogging Earnings Pipes Unclogging Earnings Pipes

Highlights The American Rescue Plan Act confirms the shift to “Big Government” and proactive fiscal policy in US politics. This sea change in policy is durable for now, given that Democrats can pass one or two more budget reconciliation bills without a Republican vote. Details of forthcoming tax hikes are starting to leak from Washington. Investors should not assume that progressive proposals like a wealth tax, a financial transactions tax, or a minimum corporate tax are dead on arrival. Taxing corporations and the rich is popular. The Republican Party is likely to choose a Trumpian agenda going forward and Trump has a good chance of being the presidential candidate in 2024. But cyclical and structural factors disfavor Republicans at this early stage. Industrials have rallied sharply in advance of Biden’s first law and are now overbought. But we would favor them over health care over a 12-month period, given the macro backdrop and relative policy risks. Feature Were there any surprises in the American Rescue Plan Act (ARPA) signed by President Biden on March 11? Only that some of Biden’s health care and infrastructure agenda slipped into the bill, alongside a provision holding that if states cut taxes and lose revenue, they will lose an equivalent amount in state and local aid. The plan illustrates that the budget reconciliation process is an effective tool for the ruling party to get most of what it wants. The Biden administration will be able to pass one or two more reconciliation bills for FY2022 and FY2023. While the next bills will be harder to pass than the first, and moderate Democratic senators will limit Congress’s options somewhat, the point is that Democrats have just enough political capital to achieve their policy agenda without a single Republican vote. As always, our Political Capital Index is updated in the Appendix and highlights falling political polarization and improving business sentiment, which is positive for Biden’s political capital.  Investors will continue to bet on a cyclical recovery but will also become more concerned about tax hikes on one hand and excessive deficit spending on the other. The latter threatens eventually to overheat the economy and speed up the Fed’s rate hike cycle. In this report we conduct a quick recap of the ARPA now that it is official law, we review the tax hike proposals swirling out of the Washington rumor mill, and we update the status of the civil war in the Republican Party. We conclude with a look at industrial stocks, which have rallied tremendously on the back of the cyclical economic upturn (Chart 1) but may still offer some value relative to sectors like health care that face policy risks. Chart 1Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus ARPA Symbolizes The ‘Big Government’ Shift The well-known provisions of the ARPA include: Treasury checks of $1,400 sent directly to individuals who earn less than $80,000 per year; extended unemployment benefits and a renewed federal top-up of $300 per week through September 6, 2021; $65 billion in business aid; and generous funding for various welfare programs such as the expanded Child Tax Credit and larger subsidies for enrollees in the Affordable Care Act health insurance marketplaces (Chart 2).1 Chart 2American Rescue Plan Act Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors In total the US fiscal stimulus amounts to $5 trillion or 23% of GDP since COVID-19 emerged, with $2.8 trillion or 13% of GDP passed since December. It is a gargantuan fiscal stimulus that will supercharge the economy today but lead to a rocky descent once it is exhausted in the coming years (Chart 3). Expiring provisions will occasion political showdowns over whether to make them permanent and how to address waste, corruption, and the long-term budget deficit. Chart 3The COVID-19 Fiscal Blowout Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The provisions are so far flung that educated American citizens living abroad are reportedly receiving stimulus checks. Nevertheless the bulk of the impact will be felt by low-income people with high marginal propensities to consume. They are the prime beneficiaries of the $850 billion share of the law that funnels cash to individuals as opposed to businesses (Chart 4). This means that at least one-third of the money will be spent, while around two-thirds will be used to pay down debt, enabling consumers to spend more later, according to our Global Investment Strategy. The general effects are very supportive of the recovery. For example, the number of children living in poverty is estimated to fall by 40%, while about one in five renters are expected to catch up on their rent.2 Evictions, bankruptcies, and loan delinquencies will not revive in this context. The total amount of spending is almost twice the size of the output gap, which is now widely expected to be filled by the end of 2022.  Chart 4Cash Handouts To Families With High Propensity To Consume Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors While ARPA mainly consists of short-term cash relief – with pro-productivity investments to come in the reconciliation bill for FY2022 focused on infrastructure and renewables – nevertheless it is not wholly devoid of long-term investment. Each of the 50 states will receive $500 million in aid (more depending on their unemployment rate). Since state and local government revenues are not as dire as expected, some of this money will go into infrastructure, including soft infrastructure like the rural broadband buildout. States will be discouraged from cutting taxes, as mentioned.3 The most important takeaway is that the ARPA will reinforce the shift in public attitudes in favor of a larger government role in the economy. Democrats passed their “liberal wish list” and the result is that a range of constituencies – from those on food and housing programs to those working in the health and education systems – will receive a windfall of federal support. In this way a one-off and probably excessive relief bill will contribute to a sea change in American attitudes toward government. Conservatives and Republicans will still argue in favor of limited government but that is a relative concept and the goalposts just moved. Bottom Line: The ARPA secures the recovery, plugs the output gap, and likely reinforces the shift in public attitudes in favor of a larger role of government in society and the economy. The amount of stimulus is likely excessive, assuming the economy avoids any other bad shocks in the coming years. Hence the law marks a historic shift from reactive to proactive fiscal policy and sets the stage for an inflation overshoot in the long run if not the short run.  Yellen Becomes Warren? Not Quite, But Expect Negative Tax Surprises The next budget reconciliation bill is expected to be a 10-year green infrastructure package that will be partially offset by tax hikes. Whether in the same bill, or prioritized above it, we expect Biden to push for his expansion of the Affordable Care Act (only a small part of his health agenda was included in the ARPA). The House will draft its version in April and Biden may sign the final bill into law as early as September or as late as December. We discussed the bill in our March 3 missive. Rumors about the tax proposals are starting to leak out of Washington. At present none of the rumors change the policy consensus, based on Biden’s campaign proposal shown in Table 1. However, they do tentatively support our view that tax hikes will deliver negative surprises to the equity market this year, given that investors have so far been unperturbed by the prospect of higher taxes. Table 1Taxman Cometh Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Secretary of Treasury Janet Yellen raised some eyebrows when she indicated that a wealth tax is being considered by the Biden administration.4 Previously a tax on a person’s (or trust’s) net assets, as opposed to a tax on their income, was the domain of Biden’s progressive-left rivals such as Senators Bernie Sanders and Elizabeth Warren. Warren’s proposal would levy a 2% annual tax on those who possess more than $50 million in net wealth, rising to 3% on billionaires. During the Democratic primary election their proposals were estimated to raise anywhere from $1.4 trillion – if Warren’s proposal met with extreme tax avoidance – to $4.5 trillion, as estimated by Sanders.5  Yellen has also spoken to the finance ministers of France and Germany as part of a diplomatic initiative through the OECD to encourage global participation in a minimum corporate tax rate of around 12%. In exchange for enacting this tax floor, Yellen signaled to the Europeans that she would not insist on providing American Big Tech with a “safe harbor” from Europe’s planned digital tax.6 Whatever ends up happening internationally, the implication is that the Biden administration will push forward with its proposed 15% minimum tax on corporation’s book income. Yellen says that she expects tax hikes to be phased in the latter part of the 10-year budget window for FY2022 so as to make sure that the government’s interest burden is manageable over the long run. She is not concerned about excess deficits or debt in the short run, as they are related to the pandemic relief and economic recovery and interest rates are below the nominal growth rate of the economy. But she has endorsed passing tax hikes for later in the decade, as did both President Biden and Vice President Kamala Harris on the campaign trail.  Several of the more ambitious tax proposals face limitations in Congress. Moderate senators like Joe Manchin of West Virginia have raised objections to a large tax hike during trying times. He might be joined by other moderates like John Tester of Montana and the four narrowly elected senators from Arizona and Georgia. However, while these moderates will keep the tax agenda in check, it is important to understand their position. None of these senators are against tax hikes in principle – that would be a Republican stance. They are against tax hikes that increase the burden on the middle class or jeopardize the economic recovery. From that point of view Biden’s proposals are fairly palatable: the highest individual income tax bracket would go back to where it stood in 2016, the corporate rate would go halfway (at most) to its pre-Trump level, and the estate tax would be restored. These proposals focus on big corporations and the wealthy and are likely to be watered down in negotiation, so we would not rule out moderate Democratic support.  Investors should not rest easy about the tax agenda until more information is known. Negative surprises are likely. The consensus is that the Democrats will not pass a wealth tax, or a “Wall Street tax” on financial transactions, or other progressive proposals. But these taxes would be popular and politically defensible – some polls even show a majority of Republicans supporting a wealth tax.  Therefore these taxes cannot be ruled out in advance.7 Bottom Line: The tax debate is underway and our expectation of negative surprises is looking more, not less, likely. How Will Republicans Respond To The Big Government Onslaught?   Republicans have duly retreated to the political wilderness after their election loss and the January 6 Capitol Hill riot. The critical question is whether and how they will regroup to contest future elections – the deeper their divisions, the more certain Democratic policy becomes. At the center of this question is whether the Republican Party will adopt Trumpist policy and whether Trump himself will continue to be the flagbearer and presumptive nominee for the presidential election in 2024. Our answer is that the Republicans will adopt a Trumpist agenda of tough trade and immigration policies combined with fiscal largesse but they will struggle over Trump himself and how to broaden their base. Every election is unique. COVID-19 reinforces the point. There is a clear case to be made that Trump would have won the election if not for the pandemic and recession. We favor this view given how narrowly he lost in the midst of the crisis. But there is also a clear case to be made that he would have lost anyway.8 The problem for the Republicans going forward is that cyclical and structural trends work against them. Cyclically, the economy should be in full stride in 2022-24 and the Federal Reserve is highly likely to play a supportive role. This may or may not prevent the usual midterm opposition gains but it will make it very hard for an opposition presidential candidate to win. True, Democrats will not have a full incumbent advantage if President Biden passes the baton to Vice President Harris. Inflation and other problems will emerge. But given the timing of the pandemic, election, and vaccine, voters will probably be much better off in four years than they were last November, which is the most reliable prediction of whether the incumbent party will stay in power.      Structurally, demographic change in America diminishes Trump’s base. A generational shift is transforming the American electorate, as the Silent Generation, which is the most reliably Republican, passes on (Chart 5). Millennials favored the Democratic Party by 6% in the 2020 election (10% in Georgia and 21% in Pennsylvania). Chart 5Generational Shift A Risk To Unreconstructed Republicans Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Ethnic minorities also skew Democratic, generally speaking, and are taking a much larger share of the electorate, especially in critical swing states – as highlighted by Biden’s victories in Arizona and Georgia (Chart 6). Hispanics favored Biden by 33% (24% in Arizona). Chart 6US Demographics Drive Political Change Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographic extrapolations by the Center for American Progress show that even if post-Millennial generations grow more conservative over time, the Electoral College will shift inexorably against the Republicans as long as current trends continue (Chart 7). Chart 7Electoral Math Frowns On Republicans Even Without Generational Shift Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographics are not destiny: Trump would never have won in 2016 if projections based on age and race were so predictive. Yet Republicans cannot merely wait on cyclical or exogenous events to discredit the Democrats. The electoral math is devastating if they do not broaden their appeal. Their quandary is that generating enthusiasm among their base of white voters with less formal education may exclude the very groups to whom they need to appeal: suburban women, educated whites, and ethnic minorities. The immediate question is what to do about Trump, who has divided the party over the Capitol riot, culminating in seven Republican votes against him in his second impeachment. On the surface the Republican Party is a much older entity than any single member or leader and can therefore play a longer strategy. It could choose the correct electoral strategy of courting independents, women, and Hispanics even if it meant losing an election or two due to divisions with the Trumpists. The problem is that Trump’s personal following is uniquely threatening to the viability of the party. Trump alone could split the Republican Party and nullify its chances in 2022-24 and beyond. Trump has suggested starting his own party, the Patriot Party. Opinion polls show that 46% of Republicans would join it while only 27%would insist on sticking with the Republican Party (Chart 8). Even if a Trumpist party stole only 2-3% of Republican voters it would be enough to ensure a Democratic victory in any election given the very small margins of victory in swing states in recent decades. Trump would easily spoil the Republican bid, just as Ross Perot did in the 1990s, Robert La Follette did for the Democrats in the 1930s, and Theodore Roosevelt did in 1912 (Table 2). As Senator Lindsey Graham said of Trump and the Republican Party, after holding post-election negotiations with the former president: “He can make it bigger. He can make it stronger. He can make it more diverse. And he also could destroy it.”9 Chart 8Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table 2Major Third Party Breakaway Candidates Undercut Their Former Party Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors So What Will Republicans Do? We conducted an exercise using game theory to determine the likeliest strategy that Trump and the party will take. We used the famous “Prisoner’s Dilemma” as our template because both sides have a lot to gain if they cooperate and a lot to lose if not.10 But they do not trust each other. And each side will lose the most if it stays true while the other betrays it, worsening the distrust. Diagram 1 shows the outcome. Republicans could win eight years in the Oval Office if they adopted Trump’s agenda yet put forward a young new candidate with Trump’s personal endorsement; or they could win four years if they chose Trump himself (the constitutional limitation). By contrast, if they chose an establishment Republican agenda, they could win eight years (reduced to four in Diagram 1 because less likely) or zero years if Trump opposed. Trump, for his part, would win zero years if he bowed out to support the Republicans regardless of whether they adopted his agenda, but he would have a chance of winning four more years if he ran at the head of a Trumpist Republican Party. The outcome is that the Republicans will adopt Trumpism while Trump himself could easily run for president again, given his sway over the party. Diagram 1Game Theory Says Republicans Will Court Trump Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The game works out the same way if we assign minimal positive payoffs (e.g. one point for a win, zero points for a loss), various other probability weighted payoffs (50% chance of winning), or negative payoffs for time spent out of power. In each variation a stable equilibrium emerges in which Republicans adopt Trump’s agenda and Trump runs again in 2024. Of course, if one changes the structure of the game or assigns subjective scores a different outcome can be produced. But the clearest and most logical games all produce the same outcome: Trump 2024.   This view fits with the consensus in online betting markets. According to the bookies, Trump has between a 20% and 35% chance of running as the Republican nominee in 2024. The same markets give Republicans a 44%-50% chance of winning the White House that year. At this early stage we would take the “over” on Trump and the “under” on a GOP victory given the above points about the cyclical and structural factors weighing against Republicans (Chart 9). Our quantitative US election model, which produced the correct result for all states except Arizona, Georgia and Michigan in 2020, gives the Republicans a 44% chance of winning in 2024 but that number will fall sharply as the economy improves. Chart 9Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 What might change this outcome, according to game theory? Republicans could offer a powerful sweetener to convince Trump to bow out of the race and support the party’s candidate, such as letting one of his children or his son-in-law Jared Kushner run in his place. Alternately Democrats could increase the danger to Trump of their winning again, perhaps by threatening to throw him in jail. Otherwise Trump may not be sufficiently convinced of his party’s loyalty, or frightened of Democratic rule, to bow out of the race.  We are never beholden to game theory and there are countless real-world ways in which the 2022-24 election outlook could change. But as things stand today, Republicans are highly likely to adopt Trump’s agenda. Trump may or may not do what is best for the party. He is unpredictable and at critical junctures over the past year he has not done so. He could start his own party just for the fun of it and in doing so break the party of Lincoln. This irrational factor creates an imbalance in the game that the Republican Party will be anxious to prevent, reinforcing its likely decision to adopt his agenda and let him seek the nomination freely. If the Republican Party does split, officially or unofficially, the Democrats will be guaranteed to expand their hold on Congress in 2022 and keep the White House in 2024. Note that Republicans would normally be heavily favored to retake the House of Representatives in 2022, though not the Senate, so such an outcome would be a political earthquake. A Democratic ascendancy could last for more than one election cycle: Republicans held the White House from 1980-92 and Democrats held it from 1932-52. Since we cannot reliably forecast Trump’s individual behavior, we cannot rule out a deep Republican rift. On the other hand, while the demographic trends point to Democratic rule out to 2036 and beyond, no Democratic ascendancy would last that long, given economic cycles, international threats, and the inevitable corruptions of single-party rule. But policy uncertainty would collapse over the 2022-24 cycle, pushing the timing of major policy change to 2026 or later. Investors would face a high probability that a sweeping Democratic agenda would be enacted, even assuming the persistence of checks and balances provided by moderate Democratic senators and the judicial branch. One clear implication is that financial markets may not evade the risk of negative regulatory and tax surprises over the long run even if they manage to do so in the FY2022 and FY2023 reconciliation bills – which we doubt. Bottom Line: Republicans cannot win the White House in 2024 without Trump’s popular base, even though they would prefer to have a fresh face capable of expanding that base. Trump cannot win without the Republican Party but he can unpredictably decide to do something other than win, i.e. endorse a Republican successor or start a third party. As a result a true Republican split cannot be ruled out. Meanwhile Republicans will have to court Trump rather than vice versa. Democratic policy is well ensconced for now, an underrated risk to the equity market. Investment Takeaways We know that Democrats are pushing forward on their legislative agenda and capable of passing one or two more budget reconciliation bills. We know that cyclical and especially structural factors will put Republicans at a disadvantage in the 2024 presidential race and possibly even the 2022 midterm. We also know that the Republican Party has a non-negligible risk of fracturing due to Trump’s personal following and unpredictability. These points suggest investors should not bet against the current policy setup. The macro backdrop favors cyclical sectors such as industrials, energy, materials, and financials. In our US Political Risk Matrix we have highlighted that the policy backdrop is especially beneficial to industrials (Appendix, Table A1). This is reinforced by ARPA and Biden’s forthcoming reconciliation bills on infrastructure and green projects, subsidies for domestic production, and simultaneous attempts to reduce trade tensions with US allies and partners – if not with China. Of course, industrials have rallied enthusiastically alongside a sharp rebound in core durable goods orders, a more gradual improvement in non-residential capital expenditures, and an environment in which capex intentions will respond to a general domestic and global upswing (Chart 10). A weak dollar, premised on a global recovery, excess liquidity, lower interest rates for longer, and large budget and trade deficits, also favors the industrial sector and reinforces the recovery in global trade and growth. Rising commodity prices are driven by supply constraints as much as global demand, as our Commodity & Energy Strategy has showed in depth, and help to restore pricing power to industrial firms  (Chart 11). Chart 10Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Chart 11Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Hence the good news is largely priced into industrials, which are tactically overvalued according to our BCA valuation indicator. The sector looks more or less expensive on all valuation metrics other than price-to-sales (Chart 12). Therefore the best value must be sought on a relative basis, where industrials are outperforming communications services and just beginning to outperform the superstars, tech and health care. From a policy point of view, health care is one of the biggest losers of the Biden administration, which aims to expand health insurance coverage and reduce drug prices. This may be for the benefit of society but it comes at the expense of old cash cows. Investors should stay guarded against a near-term correction in industrials due to looming tax hikes but strategically favor them over health care and tech (Chart 13), which are even more vulnerable to higher taxes. We will execute this trade by going long against health care over a strategic time frame. Chart 12Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Chart 13Favor Industrials Over Health Care Favor Industrials Over Health Care Favor Industrials Over Health Care Industrials also have a favorable profile against consumer discretionary stocks but we maintain a positive outlook on the US consumer in an era of government largesse. Our Geopolitical Strategy has also highlighted that Great Power struggle will prevent the Biden administration from cutting defense spending – another boon for industrials. Instead it will have to increase spending for defense as well as supply chain resilience and research and development in the midst of a cold war with China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1Political Risk Matrix Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A2Political Capital Index Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3APolitical Capital: White House And Congress Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3BPolitical Capital: Household And Business Sentiment Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3CPolitical Capital: The Economy And Markets Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A4Biden’s Cabinet Position Appointments Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors         Footnotes 1     Garrett Watson and Erica York, “The American Rescue Plan Act Greatly Expands Benefits Through The Tax Code In 2021,” Tax Foundation, March 12, 2021, taxfoundation.org.              2     Committee for a Responsible Federal Budget, “American Rescue Plan Act Will Help Millions And Bolster The Economy,” March 15, 2021, cbpp.org. 3    See footnote 2 above. 4    Paul Kiernan and Catherine Lucey, “Yellen Says Biden Administration Undecided On Wealth Tax,” Wall Street Journal, wsj.com. 5    Kyle Pomerleau, “How Much Revenue Would A Wealth Tax Raise?” On The Margin, American Enterprise Institute, April 20, 2020, aei.org. 6    Jeff Stein, “Yellen pushes global minimum tax as White House eyes new spending plan,” Washington Post, March 15, 2021, washingtonpost.com. 7     Howard Schneider and Chris Kahn, “Majority of Americans favor wealth tax on very rich: Reuters/Ipsos poll,” Reuters, January 10, 2020, reuters.com; Matthew Sheffield, “New poll finds overwhelming support for an annual wealth tax,” The Hill, February 6, 2019, thehill.com. 8    A recession could have happened as a result of the cyclical slowdown from the trade war, which hurt the Midwestern swing states. The yield curve had inverted and the economy’s margin of safety was low. There would not have been any fiscal stimulus without the pandemic. 9    James Walker, “Lindsey Graham Warns Donald Trump Could ‘Destroy’ GOP After Combative CPAC Speech,” Newsweek, March 8, 2021, newsweek.com. 10   The Prisoner’s Dilemma involves two prisoners detained separately and pressured into confessing their crimes. If they both stay quiet, nothing can be proved and they only spend one year in jail. If they both confess, they are proven guilty and both spend five years in jail. If only one of them confesses while the other stays silent, the confessor goes scot free while the other spends 20 years in jail! The incentive is to confess. The equilibrium is for both to confess. The traditional game reveals the benefits of trust as well as the difficulty of maintaining it in isolation and doubt.   

Monitoring China Closely Monitoring China Closely Deterioration in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel), and today we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel), and the risk is that the S&P 500 may be next in line (top panel), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Bottom Line: The S&P 500 is nearly perfectly priced and at a spitting distance from our 4,000 end-2021 target. China’s slowdown, especially post the 100 year Communist Party anniversary this summer, remains a key macro risk to monitor and can serve as a catalyst for an SPX correction.