Sectors

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 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 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 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 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 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 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 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 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 Table 2Major Third Party Breakaway Candidates Undercut Their Former Party 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 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 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 Chart 11Commodity 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 Chart 13Favor 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 Table A2Political Capital Index Table A3APolitical Capital: White House And Congress Table A3BPolitical Capital: Household And Business Sentiment Table A3CPolitical Capital: The Economy And Markets Table A4Biden’s Cabinet Position Appointments         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.   

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.  

Overweight The inevitable economic reopening due to the population’s inoculation along with President Biden's freshly signed fiscal spending bill will pump fresh blood into the US economy that railroads – which are the arteries of the economy – will be in charge of distributing. Already, the business sales-to-inventories ratio is picking up steam and demand for all the key rail freight categories is slated to remain robust for the rest of the year (middle panel). Tack on the broader positive macro dynamics that our earnings model does an excellent job at sniffing out, and the odds of a durable outperformance period in rails inch higher (bottom panel). Bottom Line: Boost the S&P rails index to overweight. For additional details please refer to this week’s Strategy Report. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – CSX, KSU, NSC, UNP.  

Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration.   The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Chart 5High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense.                           Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Chart 8Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3  With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Firming leading rail freight indicators signal that intermodal, coal and commodity (ex-coal) carloads are in high demand. Tack on the global economic reopening in the back half of the year and rising commodity prices, and factors are falling into place for a durable outperformance phase in rails. Boost exposure in the S&P rails index to overweight. Recovering lodging demand coupled with restrained industry capacity should restore hoteliers’ pricing power and boost profitability. The S&P hotels, resorts and cruises index remains a high-conviction overweight. Recent Changes Boost the S&P railroads index to overweight, today. On March 9, our 5% rolling stop on the S&P autos & components index was triggered and we lifted exposure to neutral that netted our portfolio 29% in relative gains since the January 25, 2021 inception. This move also augmented the S&P consumer discretionary sector back to a benchmark allocation resulting in a 7.5% gain.  Table 1 Feature While President Biden signed a new $1.9tn fiscal package into law last week, valid concerns surrounding the path of the 10-year US Treasury yield added choppiness to the stock market’s consolidation phase (Chart 1). Junk bond spreads stayed calm despite the ongoing Treasury bond market selloff and related MOVE index (bond market volatility) jump and remain a key indicator to monitor in order to gauge if a garden variety equity market pullback can morph into something more significant. Recent empirical evidence suggests that the deviation between the MOVE index and junk spreads will likely return to equilibrium via a settling down of the former, as occurred in the May 2013 taper tantrum episode (Chart 2). Chart 1Choppiness Galore Chart 2A Taper Tantrum Repeat? Importantly, delving deeper in the relationship between bonds and stocks and putting it in historical context is instructive. Our sister Emerging Markets Strategy service recently posited that in the coming years the current negative correlation between stock and bond prices will revert to positive as it prevailed prior to the Asian Crisis (Chart 3). The post-1997 era is largely characterized as disinflationary, while the period from the 1960s to the mid-1990s as primarily inflationary. As a reminder core PCE price inflation was last above the Fed’s 2.5% target in the early 1990s (please see grey zone, top panel, Chart 3). Chart 3From Inflation To Disinflation And Back To Inflation? Importantly, what will cement the correlation between stock prices and bond prices becoming definitively positive anew will be a shift upward of core PCE price inflation. Chart 4 shows that core PCE inflation leads the stock-to-bond correlation by 45 months and can serve as a confirming signpost that bonds will no longer offer downward protection to stocks and likely render risk parity useless. Chart 4Joined At The Hip, Albeit With A Lag If this paradigm shift is indeed taking root, this raises two questions: First, how will the broad equity market perform during a more persistent bond market selloff phase? Second, what equity sectors will likely outperform under such a scenario and which ones should equity investors avoid/underweight in their portfolios? Our analysis centered on historically significant bond market selloffs, which we clearly depict in the shaded areas in Chart 5. Chart 5Don’t Fear The Bond Bear Table 2 shows the results of our analysis broken down in two separate eras. Between the 1960s and the early-1990s, “the inflation era”, we use monthly data, whereas from the early-1990s onward, “the disinflation era”, we use high quality daily data. In the seven inflationary iterations the SPX median fall was 3%,1 whereas in the nine disinflationary episodes the SPX median rise was 18%.2 Impressively, since the LTCM debacle every single bond market selloff has been cheered by the stock market (Table 2). Table 2SPX Returns During Bond Bear Markets Table 3 delves deeper into GICS1 sectors and compares relative returns to the SPX during sizable bond market selloffs. Table 3US Equity Sector Returns During Bond Bear Markets During “the inflationary era” deep cyclicals outperformed the broad market, whereas early cyclicals trailed the SPX. The defensives’ performance is split down the middle with telecom and utilities faring poorly, while health care and staples outshining the SPX. One surprising result is that during “the inflationary era” relative tech performance was very resilient compared with what one would expect. There is an accentuation of relative returns in “the disinflationary era”, with all the defensives significantly underperforming and the deep cyclicals broadly outshining the SPX. Early cyclicals make a U-turn and are clear outperformers. One surprising result is the energy sector’s negative median return. Finally, the real estate sector’s significant underperformance really stands out in “the disinflationary era”. Netting it all out, the broad equity market has historically risen consistently in tandem with a bond market sell off primarily in “the disinflationary era”. Impressively, the SPX has been resilient on average even in “the inflationary era”; granted there have also been some notable drawdowns (Table 2). The implication is that at the current juncture the SPX may have some trouble digesting the bond market’s rapid selloff, but will recover smartly especially as the bond market selloff eventually proves more reflective of growth rather than restrictive. (For inclusion purposes, the appendix on page 16 shows the GICS1 sector performance since the 1960s with shaded areas depicting periods of significant bond market selloffs, and similar to Chart 3 the appendix on page 19 plots the relative share price monthly returns correlation to bond price monthly returns.) This week, we update our high-conviction overweight view on an early-cyclical sub-group with a reopening tailwind, and lift a deep cyclical transportation index to an above benchmark allocation. Hop Back On The Rails The Dow Theory is in full force and serves as a confirmation of the breakout in the Dow Industrials recently, as transports have been firing on all cylinders of late, and is also a harbinger of new all-time relative share price highs in railroads (Chart 6). Today we recommend investors get back on board the rails, a key transportation sub group, and lift exposure from neutral to overweight. Chart 6Dow Theory Green Light Leading indicators in all three key rail freight categories suggests that the railroad rebound is still in the early innings. The V-shaped recovery in the ISM manufacturing and services surveys is underpinning total rail shipments and signals that our rail diffusion indicator has more upside (Chart 7). Chart 7All Aboard… The Cass Freight Index shipments and expenditures components are also on a tear and corroborate that demand for rail freight services is robust. The upshot is that still beaten down sell-side analysts’ relative revenue growth estimates will likely surprise to the upside (Chart 8). Importantly, our Railroad Indicator does an excellent job in capturing this firming rail demand backdrop and signals that relative share price momentum has more room to rise (second panel, Chart 9). Chart 8...The Rails Chart 9Intermodal Is On Fire On the intermodal front, the back half of the year economic reopening due to the population’s inoculation along with President Biden's freshly signed fiscal spending bill suggest that retail related hauling services will pick up steam. The overall business sales-to-inventories (S/I) ratio in general and the retail S/I ratio in particular corroborate the upbeat demand outlook for intermodal carloads (third panel, Chart 9). Similarly, the LA port is as busy as ever as containerships are arriving non-stop full of cargo from China (bottom panel, Chart 9). On the commodity front, coal shipments are staging a comeback from extremely depressed levels and there is scope for a jump to expansionary territory especially given the soaring natural gas prices (second & middle panels, Chart 10). With regard to the broad commodity complex (excluding the historically large coal carload category) the demand profile for rail services is as upbeat as ever. Not only are commodity prices galloping higher, but also BCA’s Global Leading Economic Indicator is steeply accelerating painting a bright picture for rail hauling (fourth & bottom panels, Chart 10). Moreover, the surging global PMI signals that the global economic recovery is also on the ascent, which bodes well for relative profit growth (middle panel, Chart 11). Chart 10Commodity Carloads Set To Surge Chart 11Global Recovery Is A Tailwind Importantly, on the operating front our railroad industry profit margin proxy is at an historically wide level and underscores that the path of least resistance is higher for margins (Chart 11). Thus, rail profits are highly levered to industry pricing power that is on the cusp of spiking higher, especially if our thesis of the firming rail demand backdrop is accurate. The implication is that a rerating phase is in the cards for the S&P railroads index (middle panel, Chart 12). Finally, our EPS macro model has slingshot higher and suggests that rail earnings have a long runway ahead (bottom panel, Chart 12). Netting it all out, firming leading rail freight indicators signal that intermodal, coal and commodity (ex-coal) carloads are in high demand. Tack on the global economic reopening and rising commodity prices, and factors are falling into place for a durable outperformance phase in rails. Bottom Line: Boost the S&P rails index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – CSX, KSU, NSC, UNP. Chart 12Pricing Power Holds The Key   Stay Checked In To Hotels In late-November we boosted the S&P hotels, resorts & cruises index to overweight and got some eyebrows raised from our diverse client base. Subsequently, we added this niche consumer discretionary sub-group to our high-conviction overweight list for 2021 and the client pushback intensified. Today, we reiterate our high-conviction call on the S&P hotels, resorts & cruises index that has already added alpha to our portfolio to the tune of 17% since inception. While relative share price momentum has climbed of late and relative valuations have troughed, our sense is that the re-rating phase is just getting under way (Chart 13). As the global push for COVID-19 vaccinations heats up, the semblance of normality will serve as a catalyst to unlock excellent value in hotels.    True, lodging services demand is as downbeat as ever, but this index is a prime beneficiary of the reopening trade. Pent-up services demand will get unleashed with consumers likely indulging on more lavish vacationing starting this Memorial Day. Rising government transfers, a soaring savings rate and increasing incomes all augur well for lodging demand and is also corroborated by our hotels demand indicator (Chart 14). Tack on firming consumer sentiment and the ISM services index staying squarely above the 50 expansion line, and the industry’s demand outlook lifts further.   Chart 13A Valuation Re-rating Phase Looms Chart 14Leading Demand Indicators Give The All-clear Given that hotel capacity has been restrained, there are high odds that upbeat demand will likely catch hoteliers unprepared to fulfil it, and thus causing a jump in selling prices (Chart 15). Business travel is also slated to return as a flexible work place environment becomes the norm and the need to meet clients and prospects in order to conduct business will come back with a vengeance. The implication is that beaten down industry profit margins will recover smartly and boost lodging profitability especially given the collapse in the industry’s wage bill (Chart 15). Finally, our S&P hotels, resorts & cruises macro sales model encapsulates all these moving parts and signals that the budding recovery in revenue growth will gain momentum in the back half of the year (Chart 16). Chart 15Widening Margins Will Restore Profitability Chart 16Macro-based Revenue Growth Model Points To A V-shaped RecoveryAdding it all up, recovering lodging demand coupled with restrained industry capacity should restore hoteliers’ pricing power and boost profitability.   Bottom Line: We reiterate the high-conviction overweight status in the S&P hotels, resorts and cruises index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6     Footnotes 1     Given the different time frames of the bond market selloffs we decided to show annualized equity returns. 2     Ibid. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations 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

Today we take a deep dive into the S&P 500’s seasonality patterns. While over the last two decades Q1 has been the weakest quarter for stocks, on average, with March registering the steepest losses, using reconstructed S&P 500 daily data since 1928 tells a slightly different story. Interestingly, the market is fairly consistent with the upward sloping, albeit volatile, Q1 long-term seasonal trend. Historically, the weakest months are May, September and October the latter which eventually culminates into the “Santa rally”. Given that Q1 choppiness is 3/4 of the way done, Q2 should prove a lower vol quarter before investors have to contend with the seasonally weak months of September and October. Bottom Line: We reiterate our cyclically constructive broad equity market view.

Highlights The Biden administration’s early actions suggest it will be hawkish on China as expected – and the giant Microsoft hack merely confirms the difficulty of reducing strategic tensions. US-China talks are set to resume and piecemeal engagement is possible. However, most of the areas of engagement touted in the media are overrated. Competition will prevail over cooperation. Cybersecurity stocks have corrected, creating an entry point for investors seeking exposure to a secular theme of Great Power conflict in the cyber realm and beyond. Global defense stocks are even more attractive than cyberstocks as a “back to work” trade in the geopolitical context. Continue to build up safe-haven hedges as geopolitical risk remains structurally elevated and underrated by financial markets. Feature The Biden administration passed its first major law, the $1.9 trillion American Rescue Plan, on March 10. This gargantuan infusion of fiscal stimulus accounts for about 2% of global GDP and 9% of US GDP, a tailwind for risky assets when taken with a receding pandemic and normalizing global economy. The US dollar has perked up so far this year on the back of this extraordinary pump-priming and the rapid rollout of COVID-19 vaccines, which have lifted relative growth expectations with the rest of the world. Hence the dollar is rising for fundamentally positive reasons that will benefit global growth rather than choke it off. Our Foreign Exchange Strategist Chester Ntonifor argues that the dollar has 2-3% of additional upside before relapsing under the weight of rising global growth, inflation expectations, commodity prices, and relative equity flows into international markets. We agree with the dollar bear market thesis. But there are two geopolitical risks that investors must monitor: Cyclically, China’s combined monetary and fiscal stimulus is peaking, growth will decelerate, and the central government runs a non-negligible risk of overtightening policy. However, China’s National People’s Congress so far confirms our view that Beijing will not overtighten. Structurally, the US-China cold war is continuing apace under President Biden, as expected. The two sides are engaging in normal diplomacy as appropriate to a new US administration but the Microsoft Exchange hack (see below) underscores the trend of confrontation over cooperation. Chart 1Long JPY / Short KRW As Geopolitical Risk Is Underrated The second point reinforces the first since persistent US pressure on China will discourage it from excessive deleveraging at home. In a world where China is struggling to cap excessive leverage, the US is pursuing “extreme competition” with China (Biden’s words), and yet the US rule of law is intact, global investors will not abandon the US dollar in a general panic and loss of confidence. They will, however, continue to diversify away from the dollar on a cyclical basis given that global growth will accelerate while US policy will remain extremely accommodative. Reinforcing the point, geopolitical frictions are rising even outside the US-China conflict. A temporary drop in risk occurred in the New Year as a result of the rollout of vaccines, the defeat of President Trump, and the resolution of Brexit. But going forward, geopolitical risk will reaccelerate, with various implications that we highlight in this report. While we would not call an early end to the dollar bounce, we will keep in place our tactical long JPY-USD and long CHF-USD hedges. These currencies offer a good hedge in the context of a dollar bear market and structurally high geopolitical risk. If the dollar weakens anew on good news for global growth then the yen and franc will benefit on a relative basis as they are cheap, whereas if geopolitical risk explodes they will benefit as safe havens. We also recommend going long the Japanese yen relative to the South Korean won given the disparity in valuations highlighted by our Emerging Markets team, and the fact that geopolitical tensions center on the US and China (Chart 1). “Our Most Serious Competitor, China” Why are we so sure that geopolitical risk will remain structurally elevated and deliver negative surprises to ebullient equity markets? Our Geopolitical Power Index shows that China’s rise and Russia’s resurgence are disruptive to the US-led global order (Chart 2). If anything this process has accelerated over the COVID-19 crisis. China and Russia have authoritarian control over their societies and are implementing mercantilist and autarkic economic policies. They are carving out spheres of influence in their regions and using asymmetric warfare against the US and its allies. They have also created a de facto alliance in their shared interest in undermining the unity of the West. The US is meanwhile attempting to build an alliance of democracies against them, heightening their insecurities about America’s power and unpredictability (Chart 3). Chart 2Great Power Struggle Continues Massive fiscal and monetary stimulus is positive for economic growth and corporate earnings but it reduces the barriers to geopolitical conflict. Nations can pursue foreign and trade policies in their self-interest with less concern about the blowback from rivals if they are fueled up with artificially stimulated domestic demand. Chart 3Biden: ‘Our Most Serious Competitor, China’ Total trade between the US and China, at 3.2% and 4.7% of GDP respectively in 2018, was not enough to prevent trade war from erupting. Today the cost of trade frictions is even lower. The US has passed 25.4% of GDP in fiscal stimulus so far since January 1, 2020. China’s total fiscal-and-credit impulse has risen by 8.4% of GDP over the same time period. The Biden administration is co-opting Trump’s hawkish foreign and trade policy toward China, judging by its initial statements and actions (Appendix Table 1). Specifically, Biden has issued an executive order on securing domestic supply chains that demonstrates his commitment to the Trumpian goal of diversifying away from China and on-shoring production, or at least offshoring to allied nations. The Democratic Party is also unveiling bipartisan legislation in Congress that attempts to reduce reliance on China.1 These executive decrees are partly spurred on by the global shortage of semiconductors. China, the US, and the US’s allies are all attempting to build alternative semiconductor supply chains that bypass Taiwan, a critical bottleneck in the production of the most advanced computer chips. The Taiwanese say they will coordinate with “like-minded economies” to alleviate shortages, by which they mean fellow democracies. But this exposes Taiwan to greater geopolitical risk insofar as it excludes mainland China from supplies, either due to rationing or American export controls. The surge in semiconductor sales and share prices of semi companies (especially materials and equipment makers) will continue as countries will need a constant supply of ever more advanced chips to feed into the new innovation and technology race, the renewable energy race, and the buildout of 5G networks and beyond (Chart 4). It takes huge investments of time and capital to build alternative fabrication plants and supply lines yet governments are only beginning to put their muscle into it via stimulus packages and industrial policy. Chart 4Semiconductor Supply Shortage Supply shocks have geopolitical consequences. The oil shocks of the 1970s and early 1990s motivated the US to escalate its interventions and involvement in the Middle East. They also motivated the US to invest in stockpiles of critical goods and alternative sources of production so as to reduce dependency (Chart 5). Although semiconductors are not fungible like commodities, and the US has tremendous advantages in semiconductor design and production, nevertheless the bottleneck in Taiwan will take years to alleviate. Hence the US will become more active in supply security at home and more active in alliance-building in Asia Pacific to deter China from taking Taiwan by force or denying regional access to the US and its allies. China faces the same bottleneck, which threatens its technological advance, economic productivity, and ultimately its political stability and international defense. Chart 5ASupply Shortages Motivate Strategic Investments Chart 5BSupply Shortages Motivate Strategic Investments Semiconductor and semi equipment stock prices have gone vertical as highlighted above but one way to envision the surge in global growth and capex for chip makers is to compare these stocks relative to the shares of Big Tech companies in the communication service sector, i.e. those involved in social networking and entertainment, such as Twitter, Facebook, and Netflix. On a relative basis the semi stocks can outperform these interactive media firms which face a combination of negative shocks from rising interest rates, regulation, economic normalization, and ideologically fueled competition (Chart 6). Chart 6Long Chips Versus Big Tech What about the potential for the US and China to enhance cooperation in areas of shared interest? Generally the opportunity for re-engagement is overrated. The Biden administration says there will be engagement where possible. The first high-level talks will occur in Alaska on March 18-19 between Secretary of State Antony Blinken, National Security Adviser Jake Sullivan, Central Foreign Affairs Commissioner Yang Jiechi, and Foreign Minister Wang Yi. Presidents Biden and Xi Jinping may hold a bilateral summit sometime soon and the old strategic and economic dialogue may resume, enabling cabinet-level officials to explore a range of areas for cooperation independently of high-stakes strategic negotiations. However, a close look at the policy areas targeted for engagement reveals important limitations: Health: There is little room for concrete cooperation on the COVID-19 pandemic given that the pandemic is already receding, the Chinese have not satisfied American demands for data transparency, Chinese officials have fanned theories that the virus originated in the US, and the US is taking measures to move pharmaceutical and health equipment supply chains out of China. Trade: Trade is an area of potential cooperation given that the two countries will continue trading while their economies rebound. The Phase One trade deal remains in place. However, China only made structural concessions on agriculture in this deal so any additional structural changes will have to be the subject of extensive negotiations. Secretary of Treasury Janet Yellen says the US will use the “full array of tools” to ensure compliance and will punish China for abuses of the global trade system. Cybersecurity: On cybersecurity, China greeted the Biden administration by hacking the Microsoft Exchange email system, an even larger event than Russia’s SolarWinds hack last year. Both hacks highlight how cyberspace is a major arena of modern Great Power struggle, making it unlikely that there will be effective cooperation. The hack suggests Beijing remains more concerned about accessing technology while it can than reducing tensions. The Americans will make demands of China at the Alaska meetings. Environment: As for the environment, the US is a net oil exporter while China imports 73% of its oil, 42% of its natural gas and 7.8% of its coal consumption, with 40% and 10% of its oil and gas coming from the Middle East. The US wants to be at the cutting edge of renewable energy technology but it has nowhere near the impetus of China (or Europe), which are diversifying away from fossil fuels for the sake of national security. Moreover China will want its own companies, not American, to meet its renewable needs. This is true even if there is success in reducing barriers for green trade, since the whole point of diversifying from Middle Eastern oil supplies is strategic self-sufficiency. The Americans would have to accept less energy self-sufficiency and greater renewable dependence on China. Nuclear Proliferation: Cooperation can occur here as the Biden administration will seek to return to a deal with the Iranians restraining their nuclear ambitions while maintaining a diplomatic limiting North Korea’s nuclear weapons stockpile and ballistic missile development. China and Russia will accept the US rejoining the 2015 Iranian nuclear deal but they will require significant concessions if they are to join the US in forcing anything more substantial on the Iranians. China may enforce sanctions on North Korea but then it will expect concessions on trade and technology that the Biden administration will not want to give merely for the sake of North Korea. Bottom Line: The Biden administration’s China strategy is taking shape and it is hawkish as expected. It is not ultra-hawkish, however, as the key characteristic is that it is a defensive posture in the wake of the perceived failures of Trump’s strategy of “attack, attack, attack.” This means largely maintaining the leverage that Trump built for the US while shifting the focus to actions that the US can take to improve its domestic production, supply chain resilience, and coordination with allied producers. Punitive measures are an option, however, and if relations deteriorate over time, as expected, they will be increasingly relied on. Buy The Dip In Cybersecurity Stocks A linchpin of the above analysis is the Microsoft Exchange hack, which some have called the largest hack in US history, since it confirms the view that the Biden administration will not be able to de-escalate strategic tensions with China much. China has been particularly frantic to acquire technology through hacking and cyber-espionage over the past decade as it attempts to achieve a Great Leap Forward in productivity in light of slowing potential growth that threatens single-party rule over the long run. The breakdown in ties between Presidents Barack Obama and Xi Jinping occurred not only because of Xi’s perceived violation of a personal pledge not to militarize the South China Sea but also because of the failure of a cybersecurity cooperation deal between the two. When the Trump administration arrived on the scene it sought to increase pressure on China and cybersecurity was immediately identified as an area where pushback was long overdue. Cyber conflict is highly likely to persist, not only with Russia but also with China. Cyber operations are a way for states to engage in Great Power struggle while still managing the level of tensions and avoiding a military conflict in the real world. The cyber realm is a realm of anarchy in which states are insecure about their capabilities and are constantly testing opponents’ defenses and their own offensive capabilities. They can also act to undermine each other with plausible deniability in the cyber realm, since multiple state and quasi-state actors and a vast criminal underworld make it difficult to identify culprits with confidence. Revisionist states like China, North Korea, Russia, and Iran have an advantage in asymmetric warfare, including cyber, since it enables them to undermine the US and West without putting their weaker conventional forces in jeopardy. Cybersecurity stocks have corrected but the general up-trend is well established and fully justified (Chart 7). It is not clear, however, that investors should favor cybersecurity stocks over the general NASDAQ index (Chart 8). The trend has been sideways in recent years and is trying to form a bottom. Cybersecurity stocks are volatile, as can be seen compared to tech stocks as a whole, and in both cases the general trend is for rising volatility as the macro backdrop shifts in favor of higher interest rates and inflation expectations (Chart 9). Chart 7Cyber Security Stocks Corrected Chart 8Major Hacks Failed To Boost Cyber Vs NASDAQ Chart 9Volatility Of Cyber & Tech Stocks Rising Great Power struggle will not remain limited to the cyber realm. There is a fundamental problem of military insecurity plaguing the world’s major powers. Furthermore the global economic upturn and new energy and industrial innovation race will drive up commodity prices, which will in turn reactivate territorial and maritime disputes. Turf battles will re-escalate in the South and East China Seas, the Persian Gulf and Indian Ocean basin, the Mediterranean, and even the Baltic Sea and Arctic. One way to play this shift is as a geopolitical “back to work” trade – long defense stocks relative to cybersecurity stocks (Chart 10). The global defense sector saw a run-up in demand, capital expenditures, and profits late in the last business cycle. That all came crashing down with the pandemic, which supercharged cybersecurity as a necessary corollary to the swarm of online activity as households hunkered down to avoid the virus and obey government social restrictions. Cybersecurity stocks have higher EV/EBITDA ratios and lower profit margins and return on equity compared to defense stocks or the broad market. Chart 10Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics The trade does not mean cybersecurity stocks will fall in absolute terms – we maintain our bullish case for cybersecurity stocks – but merely that defense stocks will make relative gains as economic normalization continues in the context of Great Power struggle. Bottom Line: Structurally elevated geopolitical risks will continue to drive demand for cybersecurity in absolute terms. However, we would favor global defense stocks on a relative basis. The US Is Not As War-Weary As People Think America is consumed with domestic divisions and distractions. Since 2008 Washington has repeatedly demonstrated an unwillingness to confront foreign rivals over small territorial conquests. This risk aversion has created power vacuums, inviting ambitious regional powers like China, Russia, Iran, and Turkey to act assertively in their immediate neighborhoods. However, the US is not embracing isolationism. Public opinion polling shows Americans are still committed to an active role in global affairs (Chart 11). The 2020 election confirms that verdict. Nor are Americans demanding big cuts in defense spending. Only 31% of Americans think defense spending is “too much” and only 12% think the national defense is stronger than it needs to be (Chart 12). Chart 11No Isolationism Here True, the Democratic Party is much more inclined to cut defense spending than the Republicans. About 43% of Democrats demand cuts, while 32% are complacent about the current level of spending (compared to 8% and 44% for Republicans). But it is primarily the progressive wing of the party that seeks outright cuts and the progressives are not the ones who took power. Chart 12Americans Against ‘Forever Wars’ But Not Truly Dovish Biden and his cabinet represent the Washington establishment, including the military-industrial complex. Even if Vice President Kamala Harris should become president she would, if anything, need to prove her hawkish credentials. Defense spending cuts might be projected nominally in Biden’s presidential budgets but they will not muster majorities in the two narrowly divided chambers of Congress. Biden has co-opted Trump’s (and Obama’s) message of strategic withdrawal and military drawdown. He is targeting a date of withdrawal from Afghanistan on May 1, notwithstanding the leverage that a military presence there could yield in its priority negotiations with Iran. Yet he is not jeopardizing the American troop presence in Germany and South Korea, much more geopolitically consequential spheres of action in a long competition with Russia and China. While it is true (and widely known) that Americans have turned against “forever wars,” this really means Middle Eastern quagmires like Iraq and Afghanistan and does not mean that the American public or political establishment have truly become anti-war “doves.” The US public recognizes the need to counter China and Russia and Congress will continue appropriating funds for defense as well as for industrial policy. The Biden administration will increase awareness about the risks of a lack of deterrence and alliance-building. This is especially apparent given the military buildup in China. The annual legislative session has revealed an important increase in military focus in Beijing in the context of the US rivalry. Previously, in the thirteenth five-year plan and the nineteenth National Party Congress, the People’s Liberation Army aimed to achieve “informatization and mechanization” reforms by 2020 and total modernization by 2035. However, at the fifth plenum of the central committee in October, the central government introduced a new military goal for the PLA’s 100th anniversary in 2027 – a “military centennial goal” to match with the 2021 centennial of the Communist Party and the 2049 centennial goal of the founding of the People’s Republic. While details about this new military centenary are lacking, the obvious implication is that the Communist Party and PLA are continuing to shift the focus to “fighting and winning wars,” particularly in the context of the need to deter the United States. The official defense budget is supposed to grow 6.8% in 2021, only slightly higher than the 6.6% goal in 2020, but observers have long known that China’s military budget could be as much as twice as high as official statistics indicate. The point is that defense spending is going up, as one would expect, in the context of persistent US-China tensions. Bottom Line: Just as US-China cooperation will be hindered by mutual efforts to reduce supply chain dependency and support domestic demand, so too it will be hindered by mutual efforts to increase defense readiness and capability in the event of military conflict. The beneficiary of continued high levels of US defense spending and Chinese spending increases – in the context of a more general global arms buildup – will be global arms makers. Investment Takeaways Geopolitical risk remains structurally elevated despite the temporary drop in tensions in late 2020 and early 2021. The China-backed Microsoft Exchange hack reinforces the Biden administration’s initial foreign policy comments and actions suggesting that US policy will remain hawkish on China. While Biden will adopt a more defensive rather than offensive strategy relative to Trump, there is no chance that he will return to the status quo ante. The Obama administration itself grew more hawkish on China in 2015-16 in the face of cyber threats and strategic tensions in the South China Sea. Cybersecurity stocks will continue to benefit from secular demand in an era of Great Power competition where nations use cyberattacks as a form of asymmetric warfare and a means of minimizing the risks of conflict. The recent correction in cybersecurity stocks creates a good entry point. We closed our earlier trade in January for a gain of 31% but have remained thematically bullish and recommend going long in absolute terms. We would favor defense over cybersecurity stocks as a geopolitical version of the “back to work” trade in which conventional economic activity revives, including geopolitical competition for territory, resources, and strategic security. Defense stocks are undervalued and relative share prices are unlikely to fall to 2010-era lows given the structural increase in geopolitical risk (Chart 13). Chart 13Global Defense Stocks Oversold Chart 14Global Defense Stocks Profitable, Less Indebted Defense stocks have seen profit margins hold up and are not too heavily burdened by debt relative to the broad market (Chart 14). Defense stocks have a higher return on equity than the average for non-financial corporations and cash flow will improve as a new capex cycle begins in which nations seek to improve their security and gain access to territory and resources (Chart 15). Chart 15Defense Stocks: High RoE, Capex Will Revive Chart 16Discount On Global Defense Stocks Valuation metrics show that global defense stocks are trading at a discount (Chart 16).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table 1 Appendix Table 1Biden Administration's First 100 Days: Key Statements And Actions On China Footnotes 1 See Federal Register, "America’s Supply Chains", Mar. 1, 2021, federalregister.gov and Richard Cowan and Alexandra Alper, "Top U.S. Senate Democrat directs lawmakers to craft bill to counter China", Feb. 23, 2021, reuters.com.

In recent research we have highlighted the intricate relationship between stocks and bonds and how a selloff in the latter can cause some consternation in the SPX (please see Charts 7 and 9A here). Today we take a closer look at the interplay between the long-run median FOMC interest rate projections (DOTS) and the 10-year US Treasury yield. While the data only starts in 2012, we note a special episode that happened early in 2018. Virtually the same week when the 10-year US Treasury yield crossed above the long-run DOTS, the Trump corporate tax cut rally came to an abrupt halt, and the market suffered a 10% pullback (top & middle panels). As the Powell-led Fed embarked on four hikes throughout 2018 sustaining the selloff in the 10-year US Treasury bond market, the SPX remained jittery and fell 20% from the September peak to the Christmas Eve trough. Fast forward to today and while the monetary backdrop is anything but similar to 2018, the selloff in the bond market is gaining momentum. If history at least rhymes, it will take a further 100bps of tightening via a rise in the 10-year US Treasury yield before the bond market’s selloff turns from reflective to restrictive for stocks, assuming no change in the FOMC’s long-run DOTS. Bottom Line: A sizable selloff in the bond market from current levels remains a key risk to our cyclically sanguine equity market view.  

Neutral Our 5% rolling stop in the S&P automobiles & components was triggered intraday yesterday on the back of the slipping 10-year Treasury yield, forcing us to crystalize 29% in relative gains and move this early cyclical sub-group from underweight to neutral. This shift also lifts the S&P consumer discretionary sector to a benchmark allocation, locking in gains of 7.5% since the January 25, 2021 inception. Both of these indexes are hypersensitive to rising interest rates as their end-demand user is ultimately the consumer who does not like climbing borrowing costs. Moreover, TSLA in particular commands an astronomical forward P/E and a stratospheric forward P/S, underscoring that rising interest rates weigh heavily on lofty multiples. The opposite is also true.  While the US 10-year Treasury yield is likely to rise further in coming months on the back of mounting inflationary pressures, the velocity and ferocity of the up-move in yields year-to-date is in desperate need for a breather. A period of indigestion looms for the 10-year Treasury yield as there is also a near-term self-limiting aspect to the bond market’s selloff (please look forward to tomorrow’s US Sector Insight that will feature further analysis on the 10-year US Treasury and equities). Bottom Line: Book gains of 29% and 7.5% in the S&P automobiles & components and the S&P consumer discretionary indexes, respectively, since the January 25, 2021 inception, and upgrade to neutral.

Our Tesla-dominated S&P automobiles & components underweight is currently on fire (no pun intended) generating 34% in relative returns in just over a month. While our original rationale for the underweight exposure in this sub-sector remains intact, such impressive gains are forcing our hand to institute a 5% rolling stop as a portfolio management tool in order to protect profits. As a reminder, Tesla remains a mania stock that is due for a normalization phase especially given the melt up in the US 10-year Treasury yield that is weighing on still parabolic forward multiples, at the same time as new competitors are entering its end-demand market. Bottom Line: Institute a 5% rolling stop in the S&P automobiles & components index. The ticker symbols for the stocks in this index are: BLBG: S5AUCO – TSLA, GM, F, APTV, BWA. ​​​​​​​