United States

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

In yesterday’s Special Report, we initiated a long S&P oil & gas exploration & production / short S&P metals & mining market neutral trade as a way to capitalize on the China/DM growth differential on a 6 to 12-month time horizon. This trade is also a way to express our view that crude oil will likely outperform copper going forward. While we outlined the demand side of the story in the Special Report, today we touch on relative supply dynamics. Ultimately, supply of crude oil and copper is dictated by how much companies invest in capex. It allows them to dig up more commodities in the future, thus increasing supply and lowering commodity prices. The chart below illustrates this relationship for copper and crude producers and highlights that on a relative basis, copper producers’ capex meaningfully outpaced the one of oil producers (relative capex shown inverted). In short, that means that not only relative demand dynamics are a major headwind for the copper/crude oil price ratio, but the supply side of the story will also be a drag. Bottom Line: We reiterate our newly established long S&P oil & gas exploration & production / short S&P metals & mining pair trade. For more details on the rationale behind the trade, please refer to yesterday’s Special Report.

Special Report

The economic reopening has been an underlying theme throughout most of our research since last September that has allowed us, among other things, to harvest handsome gains from our long “Back-To-Work”/short “COVID-19 Winners” baskets pair trades to the tune of 42%. While in our research we primarily focused on exploiting how the pandemic affected different sectors of the US economy, in this Special Report we take an international approach. Specifically, we recommend a play that will benefit from the unfolding Chinese slowdown (China was the country that first emerged from the pandemic, and it has already gone through peak post-pandemic growth), and from the continuing recovery in developed markets (DMs) that are yet to reach their post-pandemic growth apex. Choosing The Trade Vehicle To express this cyclical 6 to 12-month time horizon trade, we chose an intra-commodity price ratio of long crude oil/short copper. Copper prices are intrinsically driven by China’s insatiable demand for commodities, and today the Middle Kingdom accounts for 60% of global copper consumption, up 200% from just 15 years ago (Chart 1, top panel)! At the same time, the crude oil market does not have a dominant end-demand consumer as even China accounts for only 15% of global consumption. The implication is that oil prices are a good proxy for global ex-China growth, whereas copper is a great China growth gauge. The bottom panel of Chart 1 also links China's consumption of copper relative to that of oil and the CPI differential between China and the rest of the world. Importantly, as DMs now enter a period of high CPI prints, the differential will dive deeper into negative territory supporting our thesis of preferring crude at the expense of copper. In the S&P 500 sector universe, Chart 2 shows that a long S&P oil & gas exploration & production (S&P O&G E&P)/short S&P metals & mining (S&P M&M) position approximates the oil-to-copper ratio. In this report we will stick to using this sub-sector level proxy. Chart 1China And Commodities Chart 2Expressing The Trade Using Sectors Review Of China’s Slowdown In December 2020, we first pointed out the risk of Chinese growth going on hiatus in the second half of 2021 serving as a catalyst to likely reset the stock market. Now that China is the center piece of our new pair trade, a brief review of Chinese macro data is in order. On the domestic front, China put a break on its fiscal stimulus programs that is not likely to change anytime soon. Since the GFC, China has a tendency to refrain from stimulating the economy – a rule that is only broken once an exogenous shock hits the system (Euro debt crisis in 2011, pop of the Chinese equity bubble in 2015, trade war in 2019, and finally the pandemic in 2020). Absent any black swan events, China’s fiscal support will continue its downward trajectory, which, at the margin, will cap future copper gains (Chart 3, bottom panel). Tack on the natural tightening from the Chinese sovereign bond market, and copper’s cyclically bullish thesis crumbles (Chart 3, middle panel). When we look at other regions that proxy mainland China, a similar message emerges. Chart 4 shows that not only is AUD/USD refusing to break above a key historical  resistance level, but also Taiwanese SAR1 building permits are sniffing out some trouble. Both of these series confirm that Chinese, and by extension, copper’s growth is likely peaking. Chart 3Troubling News At Home… Chart 4...And Abroad Chart 5A Key Driver Is Turning Finally, Chart 5 reiterates just how important China is for the S&P M&M index, which is due for a rough awakening. Review Of DM Growth The long leg of our trade relies on economic recovery in the DM region. The growth story for the US is well-known, so we will not spend much time on it besides reiterating that generous fiscal support and an accommodative Fed are here to stay for the foreseeable future, ensuring that real economic US growth will remain robust. This brings us to the next major DM player – Europe. When it came to the vaccine roll out, the old continent was slow at inoculation, which initially made for a sluggish recovery, but last month’s Eurozone PMI release showed that the common market is picking up steam. On top of that, several leading variables predict that the explosive rise in the euro area’s PMI is not a one-off print. A diffusion index comprising Swedish data remains on the ascent. Sweden is a hypersensitive economy partially focused on the early-stage production of industrials goods which makes it a good indicator of the future overall European growth. Next, the OECD’s Leading Indicator for the Eurozone that enjoys an approximately 5-6-month lead on the euro area PMI ticked up anew (Chart 6). Finally, a liquidity proxy in the form of M2 minus GDP growth reaccelerated after a brief pause emphasizing that the Eurozone’s recovery is here to stay (Chart 7). Chart 6Upbeat Soft Data Coupled… Chart 7...With Plentiful Liquidity... Chart 8 aggregates these three series into a leading model, which confirms that European PMIs will remain strong. The broader implication is that DM economic activity will remain healthy supporting higher WTI prices, at a time when China’s slowdown will be disproportionately weighing on copper prices. Chart 8...Equals Steady Eurozone PMI Dollar Context We also think that the continuing US dollar bear market, which is BCA’s and our base case view, will be more beneficial to WTI prices given their tight historical inverse correlation. Chart 9 also shows that the rally in copper prices wasn’t driven by the greenback, instead it was China stock piling of the metal in light of the recent collapse in prices that drove copper higher. If anything, the US dollar is now a headwind for copper as the massive divergence between copper prices and the greenback will likely close through a catch down phase in the former. Chart 9US Dollar Tailwinds Chart 10Enticing Industry-level Data Delving Into Sector-level Data While both the S&P O&G E&P and the S&P M&M sub-industries are highly exposed to their respective commodities, their relative pricing power closely mimics the shape of the business cycle. The implication is that oil producers are more efficient at converting their raw commodity into earnings than mining companies (Chart 10, second panel) – a feature that is also evident once we dissect income statement data (Chart 11). Mixing that with more limited wage pressures in the oil & gas industry makes for a perfect cocktail that will boost relative operating margins favoring E&P producers (Chart 10, third & bottom panels). Chart 11Clean Earnings Pipes What Is Priced In? Has the market and sell-side analysts already sniffed out this trade opportunity? The short answer is no. On a 12-month forward P/E ratio basis our long S&P O&G E&P / short S&P M&M pair trade is at the neutral zone. Similarly, on a 12-month forward P/S metric, this share price ratio is actually trading below its historical mean and in the neutral zone. The only metric that is a touch elevated is the relative net earnings revisions ratio, but again, it remains far from historical extremes (Chart 12). Switching from analysts’ forecasts to our TTM indicators, neither our Technical nor Valuation indicators are showing any signs of overbought conditions or overvaluation, respectively. Encouragingly, 6-month momentum also had a chance to reset courtesy of the recent pullback in the share price ratio, offering a compelling entry point to this trade (Chart 13). Chart 12Sell-side Is Late To The Party Chart 13Technicals Give The Go-ahead Bottom Line: Given the unfolding Chinese slowdown, yet still robust DM growth expectations, enticing sector-level data coupled with favorable technicals and valuations, it pays to initiate a long S&P oil & gas exploration & production / short S&P metals & mining market neutral trade as a way to capitalize on the China/DM growth differential on a 6 to 12-month time horizon. The ticker symbols for the stocks in the S&P 500 oil & gas exploration & production and S&P 500 metals & mining indexes are BLBG: S5OILP – COP, EOG, HES, COG, MRO, APA, PXD, DVN, FANG and BLBG: S5METL – FCX, NEM, NUE, respectively.   Arseniy Urazov Senior Analyst ArseniyU@bcaresearch.com   Footnotes 1     Taiwan (province of China).

Special Report

Highlights The Fed: The Fed will formally discuss tapering plans over the course of this summer and fall and announce the slowing of asset purchases before the end of 2021. Its labor market objectives will also be achieved in time to lift rates in 2022. Non-US Developed Markets: The central banks outside the US most likely to deliver tapering and/or outright rate hikes over the next 1-2 years are those facing housing bubbles – the Bank of Canada and Reserve Bank of New Zealand. The ECB will do nothing on rates while adjusting asset purchase programs to preserve the size of its balance sheet, while the Reserve Bank of Australia will also sit on their hands for longer. Bond Strategy Recommendations: Investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor exposure in markets where central banks will be more dovish than expected (core Europe, Australia), while limiting exposure to markets where hawkish surprises are more likely (the US, Canada, New Zealand). Feature The recovery from the 2020 COVID recession is now well underway and many investors are getting antsy about when central bankers might respond by removing monetary policy accommodation. Some central banks appear more eager than others. Both the Bank of Canada and Bank of England, for instance, have already started to reduce their rates of bond buying. Meanwhile, the US Federal Reserve is only just now starting to talk about the timing of its own tapering. This Special Report lays out a timeline for what central bank actions we should expect during the next two years. The first section focuses exclusively on the US Federal Reserve and the second section incorporates likely announcements from other central banks. Based on a comparison of our expected central bank timeline with current market prices, we conclude that investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor government bonds in countries where central banks are likely to be less hawkish than markets expect (core Europe, Australia) versus bonds from countries where hawkish surprises are more likely (US, Canada, New Zealand and, potentially, the UK and Sweden).   The Federal Reserve’s Timeline Chart 1 shows our anticipated timeline for when the Federal Reserve will make specific policy announcements between now and the start of 2024. Chart 1The Federal Reserve’s Timeline First, over the course of this summer, the Fed will initiate discussions about when to taper its asset purchases. Then, asset purchase tapering will be announced at the December 2021 FOMC meeting with purchases set to decline as of the beginning of 2022. We expect that net Fed purchases will fall to zero by the end of Q3 2022. That is, by that time the Fed will no longer be adding to its securities holdings. Rather, it will keep the size of its balance sheet constant. Then, with its balance sheet no longer growing, the Fed will begin the process of lifting interest rates. We expect the first rate hike to occur at the December 2022 FOMC meeting. Finally, some time after the fed funds rate is well above the zero bound, the Fed will try to reduce the size of its securities portfolio. How do we arrive at this timeline? Table 1A Checklist For Liftoff We start with the Fed’s forward guidance about the timing of the first rate hike (Table 1). The Fed has told us that it will lift rates off the zero bound once (i) PCE inflation is above 2%, (ii) the labor market is at “maximum employment” and (iii) inflation is expected to remain above 2% for some time. The first item on the Fed’s liftoff checklist has already been met and the third item logically follows from the other two. That is, if inflation is above 2% and the labor market is at “maximum employment” then the Fed will certainly expect inflation to remain high. This means that the second item on the Fed’s checklist is the most critical for assessing the timing of liftoff. In assessing the US labor market’s progress toward “maximum employment” we first have to define what “maximum employment” means. Based on the Fed’s communications, we infer that “maximum employment” means an unemployment rate between 3.5% and 4.5% - a range consistent with the Fed’s NAIRU estimates – and a labor force participation rate that has recovered back to pre-pandemic levels (Chart 2). Table 2 presents the average monthly growth in nonfarm payrolls that is required to reach that definition of maximum employment by specific future dates. For example, we calculate that average monthly payroll growth of 698k to 830k will cause the labor market to reach maximum employment by the end of this year. Average monthly payroll growth of 412k to 493k is required to hit the Fed’s target by the end of 2022. Chart 2Defining "Maximum Employment" Table 2Average Monthly Nonfarm Payroll Growth Required To Reach Maximum Employment By The Given Date The most recent issue of the Bank Credit Analyst posits several reasons why US employment growth will pick up steam in the coming months.1 We agree with this view and note that indicators of labor demand such as job openings, the NFIB “jobs hard to get” survey and the Conference Board’s “jobs plentiful” survey also point to accelerating employment gains.2 All told, we think that average monthly payroll growth of 412k to 493k is eminently achievable (Chart 3). This means that the Fed will hit its three liftoff criteria in time to hike rates before the end of 2022. Chart 3Max Employment By The End of 2022 Working backwards from the expected liftoff date, the Fed has said that it needs to see “substantial progress” toward the criteria listed in Table 1 before it will taper its pace of asset purchases. The definition of “substantial progress” remains somewhat unclear, but a few recent Fed communications provide some clues. First, Fed Chair Jay Powell said that he wants to see a “string of months” like the strong March employment report before it will be appropriate to reduce the pace of asset purchases. The question of how many months constitutes a “string” remains unclear, but it certainly seems plausible that we could see two or three more strong employment reports over the course of the summer. Other Fed Governors appear to agree with this timeline. Governor Randal Quarles: If my expectations about economic growth, employment, and inflation over the coming months are borne out, however, and especially if they come in stronger than I expect, then, as noted in the minutes of the last FOMC meeting, it will become important for the FOMC to begin discussing our plans to adjust the pace of asset purchases at upcoming meetings.3 Fed Vice-Chair Richard Clarida: I myself think that the pace of labor market improvement will pick up. […] It may well be the time that – there will come a time in upcoming meetings we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases …4 Fed Governor Christopher Waller: The May and June jobs report[s] may reveal that April was an outlier, but we need to see that first before we start thinking about adjusting our policy stance.5 Our takeaway from these comments is that two or three more strong employment reports, say 500k or higher, would be sufficient for the Fed to more formally discuss tapering plans. Further, several Fed Governors seem to agree with our forecast that nonfarm payroll growth will accelerate in the coming months. With that in mind, it seems reasonable to expect that the Fed will discuss tapering plans over the course of the summer and fall, and that it will have seen sufficient labor market gains to announce a formal plan before the end of this year. Assuming that a tapering announcement occurs before the end of this year and that asset purchases actually start declining as of Jan 1st 2022, we estimate that the tapering process will conclude by the end of Q3 2022. That is, the Fed will hold the size of its balance sheet constant as of that date. Chart 4Balance Sheet Growth Will End Before The First Rate Hike At the very least, the Fed will certainly bring its net purchases to zero before it lifts rates. This is because it would be incoherent for the Fed to be tightening policy through its interest rate actions while it eases policy with its balance sheet strategy. Indeed, this is the roadmap that the Fed followed leading up to the 2015 rate hike cycle (Chart 4). Finally, we note that the Fed will try to reduce the size of its balance sheet only after the process of rate hikes is well underway. This will be consistent with the last tightening cycle when the Fed waited until the funds rate was 1.5% before it pared the size of its securities portfolio (Chart 4). We also want to stress that the Fed will only try to reduce the size of its balance sheet. In fact, we doubt that this process will get very far. The main reason for our skepticism is that there is an ongoing structural issue in the Treasury market where the supply of securities keeps growing while stricter regulations make it more costly for primary dealers to intermediate trades.6 In this environment, there are strong odds that Treasury market liquidity will evaporate whenever there is a significant shock to financial markets. When that happens, the Fed will be forced to support Treasury market liquidity through large-scale purchases, as was the case during last March’s market turmoil (Chart 5). In essence, the likelihood of future shocks that will necessitate Fed intervention in the Treasury market makes it unlikely that the Fed will make much progress reducing the size of its balance sheet. Chart 5Fed Had To Support Treasury Market In March 2020 Market Expectations And Investment Implications We can get a sense of how our Fed timeline compares to consensus expectations by looking at the New York Fed’s Surveys of Market Participants and Primary Dealers (Tables 3A & 3B). Respondents to these surveys expect tapering to start in early 2022, in line with our expectations, though they generally see it taking longer for net purchases to fall to zero. Respondents also expect a later Fed liftoff date than we do and don’t see the Fed trying to reduce the size of its balance sheet until well after rate hikes have begun. Table 3ASurvey of Market Participants Expected Fed Timeline Table 3BSurvey Of Primary Dealers Expected Fed Timeline But more important for investors than survey results is what is currently priced into the yield curve. In that regard, the overnight index swap curve is priced for Fed liftoff in February 2023 and a total of 75 bps of rate hikes by the end of 2023 (Chart 6). We expect rate hikes to start earlier and proceed more quickly than that, and therefore recommend running below-benchmark duration in US bond portfolios. Chart 6Market Rate Expectations The Timelines For Other Central Banks Policymakers outside the US are facing many of the same issues that the Fed is – rapidly recovering economies coming out of the pandemic, inflation overshoots, and surging asset prices. However, not every central bank will respond at the same time, or same pace, as the Fed. In Charts 7a and 7b, we show additional timelines for two of the most important non-Fed central banks: the European Central Bank (ECB) and the BoE. We see the likely dates and policy decisions playing out as follows. Chart 7AThe ECB’s Timeline Chart 7BThe Bank Of England’s Timeline European Central Bank For the ECB, the timing of its upcoming inflation strategy review is the most critical element. That report is due to be delivered in the latter half of this year, most likely in September or October (no firm release date has been announced by the ECB). It is highly unlikely that any meaningful policy changes will be implemented before that strategic review is completed. Some ECB officials have hinted that a move to a Fed-like interpretation of the ECB inflation target, tolerating overshoots of the target to make up for past undershoots, could result from the strategy review. The more likely option will be a move to an inflation target range, perhaps a 1-3% tolerance band, that offers more policy flexibility than the current target of just below 2%. This will potentially “move the goalposts” for the ECB in a way that will make monetary tightening even less likely compared to previous cycles. Looking at past ECB tightening episodes dating back to the central bank’s inception in 1998, it is clear that a majority of countries within the euro area must be seeing inflation that is high enough, with unemployment low enough, before any policy tightening can take place. Chart 8 illustrates this point, by showing “breadth” measures for unemployment and inflation across the euro area.7 Chart 8The ECB Usually Tightens When Growth AND Inflation Are Broad Based Specifically, the chart shows the percentage of euro area countries with an unemployment rate below the OECD’s estimate of full employment (second panel), the percentage of euro area countries with headline inflation higher than one year earlier (third panel) and the percentage of euro area countries with headline inflation above the ECB’s 2% target (bottom panel). We compare those breadth measures to the actual path of policy interest rates and the size of the ECB’s balance sheet (top panel). The conclusion from the chart is that the euro area is still a long way from having the sort of broad-based rise in inflation or fall in unemployment necessary to trigger a reduction in the size of its balance sheet or actual interest rate hikes. Chart 9The ECB Is Under No Pressure To Tighten Pre-Emptively Nonetheless, our expectation is that the ECB will want to begin preparing the markets for the end of the Pandemic Emergency Purchase Program (PEPP) - which has been buying government bonds since March 2020 in a less constrained fashion than previous asset purchase programs - shortly after the inflation strategy review is concluded. Much of the euro area economy is already showing signs of rapid recovery from pandemic induced lockdowns, amid an accelerating pace of vaccinations. On top of that, the Next Generation European Union (NGEU) recovery fund is set to begin distributing funds in the final quarter of 2021, providing a meaningful lift to government investment and expected growth in 2022. It will be difficult for the ECB to justify the need for an “emergency” program like the PEPP to continue against such a growth backdrop, especially with euro area inflation no longer at the depressed levels seen in 2020. We expect the ECB to begin preparing the market for the end of PEPP heading into the December 2021 ECB policy meeting, when it will be announced that the program will not be renewed when it expires in March 2022 (Chart 9). As always for such major policy announcements, the ECB will wish to do so when there is a new set of economic forecasts used to justify any changes. This is why December – the first meeting after the strategic review is completed that will also have new forecasts – is the earliest realistic date for an announcement on the PEPP. The communication around the PEPP announcement will need to be delicate, as the PEPP has significantly increased the ECB’s footprint in European bond markets. The share of government bonds owned by the ECB has increased by anywhere from five to ten percentage points since the PEPP began (Chart 10). We expect the ECB will be forced to expand its existing Public Sector Purchase Program (PSPP) to make up for the eventual disappearance of the PEPP. This means that the PEPP will be effectively “rolled into” the PSPP, to limit the damage from a likely post-PEPP surge in bond yields in the more fragile markets like Italy, Spain and even Greece – especially with the euro now trading close to pre-2008 highs on a trade-weighted basis (Chart 11). Chart 10The PEPP Can Expire, But Cannot Disappear Chart 11ECB Must Avoid A 'PEPP Taper Tantrum' There is a chance that the ECB will want to avoid any “PEPP taper tantrum” in Peripheral European yields (and spreads versus Germany) by making an announcement on PEPP expiry and PSPP expansion at the same meeting. If that happens, we suspect it would happen in December of this year rather than sometime in the first quarter of 2022. Beyond that, the ECB will likely seek to keep financial conditions as accommodative as possible by keeping policy interest rates unchanged well into 2023, with an actual rate hike not likely until mid-2024 at the earliest. The ECB could deliver a more modest form of “tightening” before then by letting some of the cheap bank funding programs (TLTROs) expire. Although we suspect that even those programs will need to be renewed, perhaps at less attractive financing terms, to prevent an unwanted tightening of credit conditions in the euro area banking system. Bank Of England Chart 12BoE Forecasts Are Conservative Having already announced a tapering of the pace of its bond buying in early May, the BoE is likely to continue along that path over the next year. We expect the BoE, like the ECB, to make any future taper announcements when new sets of economic forecasts are published in Monetary Policy Reports. Thus, the next taper announcements are expected in August 2021, November 2021 and February 2022, with a full tapering down to zero net purchases (new buying only replacing maturing bonds) by May 2022 at the latest. The first rate hike will occur between 6-12 months after the end of tapering, possibly as early as November 2022 but, more likely in our view, sometime closer to mid-2023. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 12). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. The BoE has been one of the least active central banks in the developed world since the 2008 financial crisis. The BoE main policy rate, the Bank Rate, has been no higher than 0.75% since then, even with the BoE threatening to lift rates to higher levels many times under the leadership of former Governor Mark Carney when inflation was overshooting the bank’s 2% target. Of course, the Brexit uncertainty since mid-2016 effectively tied the hands of the central bank and prevented any possible policy tightening. Now that Brexit has actually happened, however, the BoE has more flexibility to respond to developments with UK economic growth and inflation, as needed. A possible path for the UK Cash Rate was laid out in a recent speech by BoE Monetary Policy Committee (MPC) member Gertjan Vlieghe.8 He triggered a selloff across the Gilt market with his comment that a BoE rate hike could occur as early as Q2 2022 – with the Bank Rate rising to 1.25% from the current 0.1% by 2024 - under more optimistic scenarios for UK growth and employment. His base case, however, was that the coming uptick in UK inflation will prove to be temporary, but that a move towards full employment will make the first hike more likely toward the end of 2022 with modest rate increases in 2023 and 2024 that will take the Bank Rate to 0.75% (Chart 13). Chart 13Gilts Are Vulnerable To A Hawkish Surprise Vlighe’s base case scenario on growth and interest rates is in line with the BoE’s current forecasts that call for spare capacity in the UK economy to be fully eliminated by mid-2022, with rate hikes to begin in mid-2023. That is broadly in line with our projected BoE timeline and with current pricing in the UK OIS curve, although we see risks tilted towards faster growth and inflation – and the BoE moving more aggressively than projected – over the next 12-18 months. Other Major Developed Market Central Banks Looking beyond the “Big Three” of the Fed, ECB and BoE, central bank timelines have become increasingly dependent on a single factor – the strength of domestic housing markets. House prices are booming in Canada, New Zealand and Sweden, with valuation measures like the ratio of median house prices to median incomes soaring to historical extremes according to the OECD (Chart 14). House prices are also climbing fast in the US and UK, but the valuation measures have not surpassed the peaks seen during the mid-2000s housing bubble. The housing boom has already motivated some central banks to respond by turning less dovish sooner than expected, even with unemployment rates still above pre-pandemic peaks (Chart 15).9 The BoC noted that soaring Canadian housing values motivated the taper announcement in April. The Reserve Bank of New Zealand (RBNZ) has come under political pressure over the growing unaffordability of New Zealand homes, with the government changing the central bank’s remit earlier this year to force the RBNZ to explicitly consider house price inflation when setting monetary policy. Chart 14Surging House Prices Can Turn Doves Into Hawks Chart 15These CBs Could Turn More Hawkish Before Reaching Full Employment We expect more tapering announcements from the BoC over the latter half of 2021, with a first rate hike likely sometime in the first quarter of 2022. We see the RBNZ moving aggressively, as well, tapering over the remainder of 2021 before lifting rates by the spring of 2022 at the latest. Sweden’s Riksbank will be the next central bank to turn more hawkish because of surging home values, although they will lag the pace of the BoC and RBNZ with Sweden only now beginning to emerge from lockdowns associated with a third wave of COVID-19 cases. Importantly, Australia – a country that has dealt with house price surges in the past – has seen house price valuations retreat over the past few years, even with the Reserve Bank of Australia (RBA) slashing policy rates to historic lows. The RBA also introduced yield curve control in 2020 to anchor the level of short-term bond yields, while also engaging in outright bond purchases to mitigate the rise in longer-term bond yields. With Australian inflation still remaining well below target in a year of rising global inflation, and with subdued labor costs likely to keep price pressures moderate over the next 12-18 months, we expect the RBA to move very slowly on both tapering and rate hikes. Finally, for completeness, we should note that we do not expect any policy changes from the Bank of Japan (BoJ) over the next two years, with inflation likely to remain far below the central bank’s 2% target. Non-US Investment Implications In Table 4, we show the timing of the first rate hike (i.e. “liftoff”), and the subsequent amount of total rate hikes to the end of 2024, as currently discounted in the OIS curves of the eight countries discussed in this report. We rank the countries in the table in order of liftoff dates, starting with the closest to today. Table 4The “Pecking Order” Of Central Bank Rate Hikes The RBNZ is expected to hike first in May 2022, followed by the BoC (September 2022), the Fed (February 2023), the RBA (April 2023), the Riksbank (May 2023), the BoE (May 2023), the ECB (June 2023) and the BoJ (October 2025). The cumulative amount of rate hikes discounted to the end of 2024 rank similarly: more rate increases are expected in New Zealand (167bps), Canada (150bps), the US (137bps) and Australia (113bps); while fewer rate increases are expected in the Sweden (63bps), the UK (61bps), the euro area (31bps) and Japan (7bps). According to our various central bank timelines discussed in this report, we see the risks of a rate hike coming sooner than discounted by markets in the US, Canada and New Zealand. We see central banks moving slower than markets expect in the euro area and Australia, while we see Sweden and UK priced in line with our base case views (although we see risks tilted towards a more hawkish turn faster than expected in the latter two). The story is the same in terms of cumulative rate hikes discounted in OIS curves, with markets not pricing in enough rate hikes in New Zealand, Canada and the US – and, possibly, Sweden and the UK – while pricing too many hikes in Australia and the euro area. This leads us to recommend the following country allocations in a global government bond portfolio: Underweight the US, Canada and New Zealand Overweight Australia and core Europe (and Japan) Neutral Sweden and the UK, but with a bias to downgrade. Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst June 2021 Monthly Report, "Global House Prices: A New Threat For Policymakers", dated May 27, 2021. 2 Please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 3 https://www.federalreserve.gov/newsevents/speech/quarles20210526b.htm 4 https://ca.news.yahoo.com/federal-reserve-vice-chair-richard-clarida-yahoo-finance-transcript-may-2021-173007192.html 5 https://www.federalreserve.gov/newsevents/speech/waller20210513a.htm 6 For a longer discussion of Treasury market liquidity issues please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup 2: Shocked And Awed”, dated July 28, 2020. 7 For more details, please see Global Fixed Income Strategy Report, “ECB Outlook: Walking On Eggshells”, dated May 19, 2021. 8 The full speech can be found here: https://www.bankofengland.co.uk/speech/2021/may/gertjan-vlieghe-speech-hosted-by-the-department-of-economics-and-the-ipr 9 For more details on the global housing boom, see Global Fixed Income Strategy Special Report, “Global House Prices: A New Threat For Policymakers”, dated May 28, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights We took a walk along a section of Fifth Avenue that is home to several mass affluent retailers, … : Sometimes strategists have to get out from behind their screens and take a look around, so we made a survey of the retail spaces on Fifth Avenue between 14th and 23rd Streets. … where the enormous glut of storefronts demonstrated that not every segment of the economy is subject to upward inflation pressure: We counted 78 spaces, only 49 of which were filled. It's a great time to rent retail space in the Flatiron/Union Square area and may well be in much of the rest of the country, too. Overall, the implications from our one-mile stroll appear to be constructive for financial markets and the economy: Stories about tight supplies and rising prices are getting all the headlines, but there are also pockets of the economy with excess capacity, and the inflation genie is not yet out of the bottle. Declining commercial rents help much more of the publicly traded universe than they hurt, and we still like equities. Feature Sometimes economists have to yank their heads out of the blizzard of data and models swirling around them and take a look at the real world beyond their screens. We did so last week, walking along a nine-block stretch of Manhattan’s lower Fifth Avenue. The segment, between 14th and 23rd Streets, runs from Greenwich Village’s prewar apartment buildings and nineteenth-century townhouses to the turn-of-the-century Flatiron Building, traversing the heart of Silicon Alley and running just west of some of the city’s best restaurants. Although the well-to-do long ago decamped uptown (Teddy Roosevelt’s and Edith Wharton’s childhood homes were within a block of our route), and the most elite retailers from the area’s Ladies’ Mile heyday followed, its heavy concentration of storefronts are generally filled by retailers seeking to appeal to a mass affluent constituency. In other words, it’s a nice area and one would expect those storefronts to be occupied, or in the process of being quickly refurbished to meet the needs of their next tenants, when the economy is booming. Instead, we find that only 49 of its 78 retail spaces are currently filled, leaving a whopping 37% vacancy rate.1 A two-part schematic of the properties shows the blocks from 14th to 19th Streets (Figure 1) and from 19th to 23rd Streets (Figure 2). The rendering treats every property as if it were the same size and makes no attempt to reflect its true relative scale. Blank spaces are inserted solely to balance blocks with unequal numbers of storefronts on the east and west side of the street. A vacancy’s most recent tenant is listed only when it can be definitively established by onsite and/or internet examinations. Figure 1Fifth Avenue Storefronts, 14th Street To 19th Street Figure 2Fifth Avenue Storefronts, 19th Street To 23rd Street A Tale Of (At Least) Two Economies The Many Winners The tumbleweeds blowing by the empty storefronts on Fifth Avenue illustrate the economic bifurcation that has resulted from the pandemic and the policy efforts undertaken to combat it. A handful of segments are suffering badly, which is par for the course after a recession, but an unusually high number of the rest are thriving. Many households in the bottom two-thirds of the income distribution have received more income than they would have if the pandemic had not occurred. The low-income unemployed were able to pocket more from augmented unemployment insurance (UI) benefits than they did from their jobs, while all singles earning $75,000 or less and married couples earning $150,000 or less were eligible for three rounds of economic impact payments that amounted to $3,200 per adult and $2,500 per child ($11,400 in total for a family of four). Constraints on their ability to spend their windfalls have bloated their savings and placed them on a sounder financial footing (Chart 1). Chart 1Aggregate Household Debt Is Manageable And Easy To Service Households in the upper reaches of the income distribution have seen their wealth expand as generous monetary and fiscal policy helped financial markets recover faster than you can say “exploding budget deficit.” Suburban and exurban homeowners have seen the value of their homes surge (Chart 2, top panel) and many homeowners, no matter where they reside, have been able to refinance their mortgages at lower rates (Chart 2, bottom panel), pushing down their monthly payments. Nearly all households that were able to maintain their income have saved more since the onset of COVID-19 simply because of their reduced ability to consume amidst activity restrictions (Chart 3). Chart 2Homeowners Have Had A Good Pandemic Chart 3Households' Pandemic Windfall Large-cap business borrowers, who have participated in the cascade of corporate bond issuance that has allowed them to pre-fund their cash needs, term out their debt and reduce their debt service burden, have also been among the winners. So, too, have small-business employees who continued to be paid thanks to the forgivable Paycheck Protection Program loans extended to their employers. They may not have reaped the rewards of the median unemployed worker who received UI benefits exceeding their pay by more than a third, but they did get to share in the economic impact payment bounty. Banks have escaped the credit losses that reliably accompany a recession (Chart 4) and can look forward to capital-boosting loan-loss reserve releases as the year proceeds. Chart 4Banks Have Had A Good Pandemic, Too The Losers Chart 5CRE Weakness Is Not A Systemic Threat The reason why the forgoing list of winners is so long, and indeed, why equities and credit have had such a good recession, is because Congress and the Fed stitched together an enormous safety net. It couldn’t break everyone’s fall, however, and so there have been some losers. At the top of the list are the proprietors of PPP businesses, like restaurants, bars, concert venues and independent theaters, which have operated at partial capacity (at best) or have simply seen demand evaporate as cities cleared out and office workers remained home. On the territory covered by our walking survey, Eisenberg’s,2 which had occupied the same space opposite the Flatiron Building from 1929 to 2020, is the poster child for this unfortunate group. These independent businesses’ landlords or the lenders who hold their mortgages must be feeling the pinch, too. Despite rock-bottom interest rates that have pushed down the cost of financing property purchases, retail property cap rates (akin to the inverse of their P/E ratios) have been creeping higher, reaching a seven-year high in March, per Real Capital Analytics data on Bloomberg. It is easy to envision portfolios of properties on the nine blocks of our survey generating losses, as even one space with no revenue can be enough to make a handful of properties a loser. It is also easy to see landlords missing mortgage payments. The good news for the financial system is that overall bank exposure to commercial real estate (CRE) loans is at the low end of its 35-year range (Chart 5, top panel), with small banks holding two-thirds of them (Chart 5, bottom panel). While CRE loans account for a quarter of small banks’ aggregate loan book, they comprise just 6% of large banks’ lending portfolios (Chart 5, middle panel). A CRE credit event would sting commercial mortgage-backed security (CMBS) investors, like the life insurers and pension funds that have been avid CMBS buyers, but it would not have any meaningful adverse impact on the availability of credit. Investment Takeaways From A Mile Of New York City Sidewalk Falling rents will help S&P 500 profit margins. Supply and demand dictate that retail rents on Fifth Avenue between 14th and 23rd Streets will fall. 37% of its spaces are empty and they are owned by a patchwork of individual landlords, represented by at least five separate CRE brokers. Competition among the landlords to rent the spaces – to get any revenue in the door to offset the fixed outflows for mortgage payments and property taxes – will be fierce, just as it will among the brokers seeking to capture commissions, and it should preclude any potential for supplier collusion. This is a lessees’ market if there ever was one. Table 1Tenants Outweigh Landlords In The S&P 500 The Fall 2020 edition of the semi-annual retail rent report compiled by the Real Estate Board of New York (REBNY) echoes that conclusion. The “decreases [in average asking price-per-square foot rents] are historic, with 11 corridors [of the 17 surveyed] experiencing their lowest … averages in at least a decade. While asking rents dropped significantly, taking rents can be much lower, with some brokers citing average differences … around 20%. Increases in retail availabilities and feedback from … brokers indicate that we are in a tenant’s market.”3 The vacancy picture is not so bleak everywhere across the country, but many shopping center, strip mall and enclosed mall owners are likely to have to drop prices or ease terms to entice tenants. A shift in surplus from landlords to retail tenants should be afoot nationally, just as it should be from office owners to office tenants. Those surplus shifts will benefit S&P 500 earnings, as the aggregate market capitalization of retailers with a physical store presence far outstrips the market cap of retail REITs, and the aggregate market cap of S&P 500 constituents that rent office space dwarfs the market cap of office REITs (Table 1). Brick-and-mortar retail isn’t dead. Chart 6Absence Makes The Heart Grow Fonder The rise of internet retailing has been perhaps the single biggest business development of the twenty-first century, and last spring’s lockdowns accelerated its already rapid market share gains. But e-commerce has lost some share in the early stages of relaxed restrictions and it will presumably lose more once a fully reopened economy allows people to re-engage in public activities (Chart 6). We do not challenge the proposition that e-commerce will take an even greater share of retail sales in the future, but the revealed preferences of retailers indicate that they believe it is important to maintain a physical presence. Retailers like The Gap, with three of its brands occupying the entire western side of Fifth from 17th to 18th Streets as well as the storefront at the southeast corner of Fifth and 18th (Figure 1), tout the strategic advantages of their omnichannel platforms, marrying a robust online presence with a well-located portfolio of physical stores. One could easily hawk Harry Potter-themed wares on the internet, but the impending opening of the massive Harry Potter store on the southeast corner of 22nd and 5th has generated buzz among the Peta children that would not have occurred virtually, given the cruel and horribly unfair restrictions that limit their online exposure. It and other brick-and-mortar retail concerns will find it easier to turn a profit in the current rental market.4 As both The Gap and lululemon noted in their earnings calls for the quarter ended January 31st, reduced rents contributed to wider gross margins. Runaway inflation is not a foregone conclusion, at least not any time soon. Central banking critics have been calling for runaway inflation ever since the Fed cut rates to zero and launched its large-scale asset purchases program in December 2008. They were further inflamed by QE2 in 2010 and QE3 in 2012, but their End-Is-Near warnings failed to come to pass. We expect that the combination of maximally easy monetary policy and fiscal largesse on an unprecedented scale may well produce annual consumer price increases that break out of the sleepy range that’s prevailed over the last two decades. As our previous two Strategy Reports have detailed, however, we don’t think the breakout is going to occur any time soon. The release of pent-up demand is sure to overwhelm restrained post-pandemic capacity in many segments of the economy. As a friend making travel arrangements from Washington, DC to Chicago for his daughter’s just-opened graduation ceremony reports, there were barely any available seats on flights and finding a hotel room in the Windy City was especially difficult. Inflation in those segments will be offset to some degree by commercial rent deflation, however, along with falling prices for used bar and restaurant equipment. Furthermore, we are confident that individuals and businesses throughout the economy will ramp up capacity as soon as it appears likely to be profitable. Employment will come back. All but the newest publicly traded retailers are actively engaged in rationalizing their physical store footprints, but Fifth Avenue’s vacant storefronts will not remain empty forever. Neither will all the spaces that held now-shuttered restaurants, bars and entertainment venues. There will be money to be made from the release of a year-plus of pent-up demand and sole proprietors, small businesses and national chains will jockey to capture their share of it. Any publicly traded company needs growth to satisfy the stock market and any concern that wishes to be acquired needs growth to obtain the highest possible sales price. Even if recovering retail activity initially takes the form of clusters of pop-up stores, conventional leases will again be signed once entrepreneurs get the sense that the demand to support business is here to stay. And once the businesses come, the employees to staff them will follow. April 2020 through May 2021 may have been a great fourteen months to be unemployed, but the United States is far from an idler’s paradise. When contractors’ and gig workers’ temporary UI benefit eligibility, along with the federal UI benefit supplement, expire everywhere by September and as early as June or July in 21 states and counting, people will return to work. Intervention creates winners and losers. If the authorities can’t bail out everyone when shocks hit the economy, there will be an observable divide between those who received support and those who didn’t. The gap between the winners and the losers may undermine social cohesion, but disparities offer professional investors an opportunity to separate themselves from the crowd. It might be a good time to acquire retail properties with sound longer-run prospects from holders whose financial positions may have become untenable. It may also be a good time to acquire businesses in the worst-hit segments, or to team up with the people who have the expertise to run them. Equities still have the wind at their back. When we came out from behind our terminal to do some first-hand research on Fifth Avenue, we also took note of the televised scenes from Madison Square Garden, less than a mile away to the north and west, and from Kiawah Island, off the coast of South Carolina. The spontaneous joy on display at the Garden and NBA playoff venues across the country as fans were once again able to come together to cheer on their favorite teams, and at the site of the PGA Championship, where the gallery engulfed popular soon-to-be champion Phil Mickelson and his playing partner as they made their way to the eighteenth green,5 leads us to believe that consumers are ready to be released from the past year’s constraints and gather, celebrate and spend. Looking around, we get the sense that a new, post-COVID chapter may have begun in the US. If the whole country is as keyed up as sports fans were two weekends ago, our view that corporate earnings growth can surpass even currently elevated expectations appears to be on track. As long as the virus truly is in retreat, equities will remain the place to be. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 We conducted our in-person survey of the properties on Sunday, May 23rd and Monday, May 24th from the sidewalk, without accessing any of the vacant spaces. Our 78-space count is based on the properties’ current configuration, which is subject to change upon alterations by the properties’ owners. 2History – Eisenbergs NYC 3 REBNY Research, "Manhattan Retail Report (Fall 2020)." Accessed May 27, 2021. 4 REBNY’s Fall 2020 Retail Rent Report found that mean asking rents on Fifth Avenue from 14th to 23rd had fallen by 22% year-over-year and noted that effective rents have reportedly been much lower than asking rents. 5Golf crowd pours onto Ocean Course, mobs Mickleson on 18 | The State