Currencies

Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory.  Chart 5The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13).  Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial Conditions Chart 15Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency.  Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16).  This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It Once Was Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance  

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, April 1 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Growth outlook: The global economy will rebound over the course of the year, with momentum rotating from the US to the rest of the world. Inflation: Structurally higher inflation is not a near-term risk, even in the US, but could become a major problem by the middle of the decade. Global asset allocation: Investors should continue to overweight equities on a 12-month horizon. Unlike in the year 2000, the equity earnings yield is still well above the bond yield. Equities: Value stocks will maintain their recent outperformance. Investors should favor banks and economically-sensitive cyclical sectors, while overweighting stock markets outside the US. Fixed income: Continue to maintain below average interest-rate duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: While the dollar could strengthen in the near term, it will weaken over a 12-month period. Large budget deficits, a deteriorating balance of payments profile, and an accommodative Fed are all dollar bearish. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Strong Chinese growth will continue to buoy the metals complex. I. Macroeconomic Outlook Global Growth: The US Leads The Way… For Now The global economy should rebound from the pandemic over the remainder of the year. So far, however, it has been a two-speed recovery. Whereas the Bloomberg consensus has US real GDP growing by 4.8% in the first quarter, analysts expect the economies in the Euro area, UK, and Japan to contract by 3.6%, 13.3%, and 5%, respectively. Chart 1Dismantling Of Lockdown Measures Occurring At Varying Pace Chart 2US Is Among The Vaccination Leaders Two things explain US growth outperformance. First, the successful launch of the US vaccination campaign has allowed state governments to begin dismantling lockdown measures (Chart 1). Currently, the US has administered 40 vaccine shots for every 100 inhabitants. Among the major economies, only the UK has performed better on the vaccination front (Chart 2). In contrast, parts of continental Europe are still battling a new wave of Covid infections, prompting policymakers there to further tighten social distancing rules. Second, US fiscal policy has been more stimulative than elsewhere (Chart 3). On March 11, President Biden signed the $1.9 trillion American Rescue Plan Act into law. Among other things, the Act provides direct payments to lower- and middle-class households, extends and expands unemployment benefits, and offers aid to state and local governments (Chart 4). Unlike President Trump’s Tax Cuts and Jobs Act, the Democrats’ legislation will raise the incomes of the poor much more than the rich (Chart 5). Chart 3The US Tops The Stimulus Race We expect growth leadership to shift from the US to the rest of the world in the second half of the year. Nevertheless, US real GDP in Q4 of 2021 will probably end up 7% above the level of Q4 of 2020, enough to close the output gap. In Section II of this report, we discuss whether this could cause inflation to take off on a sustained basis. We conclude that such an outcome is unlikely for the next two years. However, materially higher inflation is indeed a risk over a longer-term horizon. Chart 4Composition Of The American Rescue Plan Act Chart 5Biden’s Package Will Boost The Income Of The Poor More Than The Rich   The EU: Recovery After Lockdown The EU will benefit from a cyclical recovery later this year as the vaccination campaign picks up steam. The recent weakness in Europe was concentrated in services (Chart 6). The latest European PMI data shows that the service sector may have turned the corner. As in the US, European households have accumulated significant excess savings. The unleashing of pent-up demand should drive consumption over the remainder of the year (Chart 7). Chart 6For Now, The Service Sector Is Doing Better In The US Than The Euro Area Chart 7European Households Have Accumulated Excess Savings Meanwhile, the manufacturing sector continues to do well, with the Euro area manufacturing PMI hitting all-time highs in March. Sentiment indices such as the Sentix and ZEW surveys point to further upside for manufacturing activity (Chart 8).   Chart 8Positive Outlook For Euro Area Manufacturing Activity Fiscal policy should also turn modestly more expansionary. The EU recovery fund will begin disbursing aid in the second quarter. This should allow the southern European economies to maintain more generous levels of fiscal support. It also looks increasingly likely that the Green Party will either lead or join the coalition government in Germany, which could translate into greater spending. UK: Recovering From A One-Two Punch The UK had to shutter its economy late last year due to the emergence of a new, more contagious, strain of the virus. The resulting hit to the economy came on top of a decline in exports to the EU following Brexit. The economic picture will improve over the coming months. Thanks to the speedy vaccination campaign, the government plans to lift the “stay at home” rules on March 29. Most retail, dining, and hospitality businesses are scheduled to reopen on April 12. A strong housing market and the extension of both the furlough schemes and tax holidays should also sustain demand. Japan: More Fiscal Support Needed Like many other countries, Japan had to introduce new lockdown measures in late 2020 after suffering its worst wave of the pandemic. While the number of new cases has dropped dramatically since then, they have edged up again over the past two weeks. Japanese regulations require that vaccines be tested on Japanese people. Prime Minster Yoshihide Suga has promised that vaccine shots will be available to the country’s 36 million seniors by the end of June. However, with less than 1% of the population vaccinated so far, strict social distancing will persist well into the summer. The Japanese government passed a JPY 73 trillion (13.5% of GDP) supplementary budget in December. However, only 40 trillion of that has been allocated for direct spending. Due to negative bond yields, the Japanese government earns more interest than it pays on its debt. It should be running much more expansionary fiscal policy. China: Policy Normalization, Not Deleveraging Chart 9China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China’s combined credit/fiscal impulse peaked late last year (Chart 9). The impulse leads growth by about six months, implying that the tailwind from easier monetary and fiscal policies will fade over the rest of the year. Nevertheless, we doubt that China’s economy will experience much of a slowdown. First and foremost, the shock from the pandemic should fade, helping to revive consumer and business confidence. Second, the Chinese authorities are likely to pursue policy normalization, rather than outright deleveraging. Jing Sima, BCA’s chief China strategist, expects the general government deficit to remain broadly stable at 8% of GDP this year. She also thinks that the rate of credit expansion will fall by only 2-to-3 percentage points in 2021, bringing credit growth back in line with projected nominal GDP growth of 8%. Total credit was 290% of GDP at end-2020. Thus, credit growth of 8% would still generate 290%*8%=23% of GDP of net credit formation, providing more than enough support to the economy. II. Feature: Will The US Economy Overheat? As of February, US households were sitting on around $1.7 trillion in excess savings. About two-thirds of those savings can be chalked up to reduced spending during the pandemic, with the remaining one-third arising from increased transfer payments (Chart 10). The recently passed stimulus bill will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. This cash hoard will support spending. Already, real-time measures of economic activity have hooked up. Traffic congestion in many US cities is approaching pre-pandemic levels. OpenTable’s measure of restaurant occupancy is progressing back to where it was before the pandemic (Chart 11). J.P. Morgan reported that spending using its credit cards rose 23% year-over-year in the 9-day period through to March 19 as stimulus payments reached bank accounts. Anecdotally, airlines and cruise line companies have been expressing optimism on the back of a surge in bookings. Chart 10Lower Spending And Higher Income Led To Mounting Excess Savings Chart 11Real-Time Measures Of Economic Activity Have Hooked Up   Meanwhile, the supply side of the economy could face temporary constraints. Under the stimulus bill, close to half of jobless workers will receive more income through to September from extended unemployment benefits than they did from working. This could curtail labor supply at a time when firms are trying to step up the pace of hiring. The Fed Versus The Markets In the latest Summary of Economic Projections released last week, the median “dot” for the fed funds rate remained stuck at zero through to end-2023. The bond market, in contrast, expects the Fed to start raising rates next year. Why is there a gap between the Fed and market expectations? Part of the answer is that the “dots” and market expectations measure different things. Whereas the dots reflect a modal, or “most likely” estimate of where short-term rates will be over the next few years, market expectations reflect a probability-weighted average. The fact that rates cannot fall deeply into negative territory – but can potentially rise a lot in a high-inflation scenario – has skewed market rate expectations to the upside. That said, there is another, more fundamental, reason at work: The Fed simply does not think that a negative output gap will lead to materially higher inflation. The “dots” assume that core PCE inflation will barely rise above 2% over the next two years, even though, by the Fed’s own admission, the unemployment rate will fall firmly below NAIRU in 2023 (Chart 12). Chart 12The Fed Sees Faster Recovery, Same Rate Path Chart 13Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Is the Federal Reserve’s relaxed view towards inflation risk justified? The Fed knows full well that headline inflation could temporarily reach 4% over the next two months due to base effects from last year’s deflationary shock, lingering supply chain disruptions, the rebound in gasoline prices, and the lagged effect from dollar weakness. However, as it did in late 2011, when headline inflation nearly hit 4% and producer price inflation briefly topped 10%, the Fed is inclined to regard these price shocks as transitory (Chart 13). The Fed believes that PCE inflation will tick up to 2.4% this year but then settle back down to 2% by the end of next year as supply disruptions dissipate and most fiscal stimulus measures roll off. Our bet is that the Fed will be right about inflation in the near term, but wrong in the long term. That is to say, we think that core inflation will probably remain subdued for the next two years, as the Fed expects. However, inflation is poised to rise significantly towards the middle of the decade, an outcome that is likely to surprise both the Fed and market participants. War-Time Inflation, But Which War? In some respects, the Fed sees the current environment as resembling a war, except this time the battle is against an invisible enemy: Covid-19. Chart 14 shows what happened to US inflation during WWI, WWII, the Korean War, and the Vietnam War. In the first three of those four wars, inflation rose but then fell back down after the war had concluded. That is what the Fed is counting on. What about the possibility that the coming years could resemble the period around the Vietnam War, where inflation continued to rise even though the number of US military personnel engaged in the conflict peaked in 1968?   Chart 14Inflation During Wartime: Which War Is Most Relevant For Today? Chart 15Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In the near term, this does not appear to be a major risk. In 1966, when the war effort was ramping up, the US unemployment rate was two percentage points below NAIRU (Chart 15). As of February, US employment was still more than 5% below pre-pandemic levels.   Chart 16Employment Has Been Weak And Edging Lower At The Bottom Quartile Of The Wage Distribution We estimate that the US output gap currently stands at around 5%-to-6% of GDP. Among the bottom quartile of the wage distribution, employment is 20% below pre-pandemic levels, and has been edging lower, not higher, since last October (Chart 16). Thus, for now, hyperbolic talk of how fiscal stimulus is crowding out private-sector spending is unwarranted. Inflation Nation Looking further out, the parallels between today and the late sixties are more striking. As we discussed in a report titled 1970s-Style Inflation: Yes, It Could Happen Again, much of what investors believe about how inflation emerged during the late 1960s is either based on myths, or at best, half-truths. To the extent that there are differences between today and that era, they don’t necessarily point to lower inflation in the coming years. For example, in the late sixties, the baby boomers were entering the labour force, supplying the economy with a steady stream of new workers. This helped to temper wage pressures. Today, baby boomers are leaving the labour force. They accumulated a lot of wealth over the past 50 years – so much so that they now control more than half of all US wealth (Chart 17). Over the coming two decades, they will run down that wealth, implying that household savings rates could drop. By definition, a lower savings rate implies more spending in relation to output, which is inflationary. Chart 17Baby Boomers Have Accumulated A Lot Of Wealth III. Financial Markets A. Portfolio Strategy Overweight Stocks Versus Bonds Stocks usually outperform bonds when economic growth is strong and money is cheap (Chart 18). The end of the pandemic and ongoing fiscal stimulus should support growth over the next 12-to-18 months, allowing the bull market in equities to continue. With inflation slow to rise, monetary policy will remain accommodative over this period. Chart 18AStocks Usually Outperform Bonds When Economic Growth Is Strong... Chart 18B... And Money Is Cheap The recent back-up in long-term bond yields could destabilize stocks for a month or two. However, our research has shown that as long as bond yields do not rise enough to trigger a recession, stocks will shrug off the effect of higher yields (Chart 19 and Table 1). Indeed, there is a self-limiting aspect to how high bond yields can rise, and stocks can fall, in a setting where inflation remains subdued. Higher bond yields lead to tighter financial conditions. Tighter financial conditions, in turn, lead to weaker growth, which justifies an even longer period of low rates. It is only when inflation rises to a level that central banks find uncomfortable that tighter financial conditions become desirable. We are far from that level today. Chart 19What Happens To Equities When Treasury Yields Rise?   Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover   It’s Not 2000 In recent months, many analysts have drawn comparisons between the year 2000 and the present day. While there are plenty of similarities, ranging from euphoric retail participation to the proliferation of dubious SPACs and IPOs, there is one critical difference: The forward earnings yield today is above the real bond yield, whereas in 2000 the earnings yield was below the bond yield (Chart 20). The US yield curve inverted in February 2000, with the 10-year Treasury yield peaking a month earlier at 6.79%. An inverted yield curve is one of the most reliable recession predictors. We are a far cry from such a predicament today. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 20% in real terms for equities to underperform bonds. Many other stock markets would have to decline by an even greater magnitude (Chart 21). Chart 20Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Chart 21Stocks Would Need To Fall A Lot For Equities To Underperform Bonds   Protecting Against Long-Term Inflation Risk The bull market in stocks will end when central banks begin to fret over rising inflation. In the past, central banks have used forecasts of inflation to decide when to raise rates. The Federal Reserve’s revised monetary policy framework, which focuses on actual rather than forecasted inflation, almost guarantees that inflation will overshoot the Fed’s target. This is because monetary policy fully affects the economy with a lag of 12-to-18 months. By the time the Fed decides to clamp down on inflation, it will have already gotten too high. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios, favor inflation-protected securities over nominal bonds, and own more “real assets” such as property. In fact, one of the best inflation hedges is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades, you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms. Gold Versus Cryptos Historically, gold has offered protection against inflation. Increasingly, many investors have come to believe that cryptocurrencies are a better choice. We disagree. As we recently discussed in a report titled Bitcoin: A Solution In Search Of A Problem, not only are cryptocurrencies such as Bitcoin highly inefficient mediums of exchange, they are also likely to turn out to be poor stores of value. Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 22). About 70% of Bitcoin mining currently takes place in China, mainly using electricity generated by burning coal. Much of the rest of the mining takes place in countries such as Russia and Belarus with dubious governance records. Bitcoin and ESG are heading for a clash. We suspect ESG will win out. Chart 22Bitcoin Is Not Your Eco-Currency B. Equities Favor Cyclicals, Value, And Non-US Stocks Chart 23Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing The vast majority of stock market capitalization today is concentrated in large multinational companies that are more leveraged to global growth rather than to the growth rate of countries in which they happen to be domiciled. Thus, while country-specific factors are not irrelevant, regional equity allocation often boils down to figuring out which stock markets will gain or lose from various global trends. The end of the pandemic will prop up global growth. In general, cyclical sectors outperform when global growth is on the upswing (Chart 23). As Table 2 illustrates, stock markets outside the US have more exposure to classically cyclical sectors such as industrials, energy, materials, and consumer discretionary that usually shine coming out of a downturn. This leads us to favor Europe, Japan, and emerging markets. We place banks in the cyclical category because faster economic growth tends to reduce bad loans, while also placing upward pressure on bond yields. Chart 24 shows that there is a very close correlation between the relative performance of bank shares and long-term bond yields. As government yields trend higher, banks will benefit. Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Chart 24Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Banks and most other cyclical sectors dominate value indices (Table 3). Not only is value still exceptionally cheap in relation to growth, but traditional value sectors have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 25). The likelihood that global bond yields put in a secular bottom last year, coupled with the emergence of a new bull market in commodities, makes us think that the nascent outperformance of value stocks has years to run.   Table 3Breaking Down Growth And Value By Sector Chart 25AValue Is Attractive On Multiple Levels (I) Chart 25BValue Is Attractive On Multiple Levels (II) US Corporate Tax Hikes Coming Finally, there is one country-specific factor worth mentioning, which reinforces our view of favoring non-US, cyclical, and value stocks: US corporate taxes are heading higher. BCA’s geopolitical strategists expect the Biden Administration and the Democrat-controlled Congress to raise the statutory corporate tax rate from 21% to as high as 28% later this year in order to fund, among other things, a major infrastructure investment program. Capital gains taxes will also rise. While tax hikes are unlikely to bring down the whole US stock market, they will detract from the relative performance of US stocks compared with their international peers. Cyclical sectors will benefit from the infrastructure spending. To the extent that such spending boosts growth and leads to a steeper yield curve, it should also benefit banks. In contrast, tech companies outside the clean energy sector will lag, especially if the bill introduces a minimum corporate tax on book income and raises taxes on overseas profits, as President Biden pledged to do during his campaign. C. Fixed Income Expect More US Curve Steepening As discussed above, inflation in the US and elsewhere will be slow to take off. However, when inflation does rise later this decade, it could do so significantly. Investors currently expect the Fed to start raising rates in December 2022, bringing the funds rate to 1.5% by the end of 2024 (Chart 26). In contrast, we think that a liftoff in the second half of 2023, preceded by a 6-to-12 month period of asset purchase tapering, is more likely. This implies a modest downside for short-dated US bond yields. Chart 26The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 Chart 27Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels In contrast, long-term yields will face upward pressure first from strong growth, and later from higher inflation. The 5-year/5-year forward TIPS yield currently stands at 0.35%, which is still below pre-pandemic levels (Chart 27). Given structurally looser fiscal policy, the 5-year/5-year forward TIPS yield should be at least 50 basis points higher, which would translate into a 10-year Treasury yield of a bit over 2%. Regional Bond Allocation While the Fed will be slow out of the gate to raise rates, most other central banks will be even slower. The sole exception among developed market central banks is the Norges bank, which has indicated its intention to hike rates in the second half of this year. Conceivably, Canada could start tightening monetary policy fairly soon, given strong jobs growth and a bubbly housing market. While the Bank of Canada is eager to begin tapering asset purchases later this year, our global fixed-income strategists suspect that the BoC will wait for the Fed to raise rates first. An early start to rate hikes by the Bank of Canada could significantly push up the value of the loonie, which is something the BoC wants to avoid. New Zealand will also hike rates shortly after the Fed, followed by Australia. Bank of England governor Andrew Bailey has downplayed the recent rise in gilt yields. Nevertheless, the desire to maintain currency competitiveness in the post-Brexit era will prevent the BoE from hiking rates until 2024. Among the major central banks, the ECB and the BoJ will be the last major central banks to raise rates. Putting it all together, our fixed-income strategists advocate maintaining a below-benchmark stance on overall duration. Comparing the likely path for rate hikes with market pricing region by region, they recommend overweighting the Euro area and Japan, assigning a neutral allocation to the UK, Canada, Australia, and New Zealand, and an underweight on the US. Credit: Stick With US High Yield Corporates Corporate spreads have narrowed substantially since last March. Nevertheless, in an environment of strong economic growth, it still makes sense to favor riskier corporate credit over safe government bonds. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over Euro area bonds. The former trade with a higher yield and spread than the latter (Chart 28). CHART 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Chart 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit-sensitive asset starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the middle of the distribution. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the Euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 29). Chart 29US High-Yield Stands Out The Most D. Currencies Faster US Growth Should Support The Dollar In The Near Term… Chart 30US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The US has a “low beta” economy. Compared to most other economies, the US has a bigger service sector and a smaller manufacturing base (Chart 30). The US economy is also highly diversified on both a regional and sectoral level. This tends to make US growth less volatile than growth abroad. The relatively low cyclicality of the US economy has important implications for the US dollar. While the US benefits from stronger global growth, the rest of the world usually benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, dragging down the value of the dollar. This relationship broke down this year. Rather than lagging other economies, the US economy has led the charge thanks to bountiful fiscal stimulus and a successful vaccination campaign. As growth estimates for the US have been marked up, the dollar has caught a temporary bid (Chart 31). Chart 31US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar … But Underlying Fundamentals Are Dollar Bearish As discussed earlier in the report, growth momentum should swing back towards the rest of the world later this year. This should weigh on the dollar in the second half of the year. To make matters worse for the greenback, the US trade deficit has ballooned in recent quarters. The current account deficit, a broad measure of net foreign income flows, rose by nearly 35% to $647 billion in 2020. At 3.1% of GDP, it was the largest shortfall in 12 years (Chart 32). Consistent with the weak balance of payments picture, the dollar remains overvalued by about 10% on a purchasing power parity basis (Chart 33). Chart 32The Widening US External Gap Chart 33The Dollar Is Expensive Based On Its PPP Fair Value Historically, the dollar has weakened whenever fiscal policy has been eased in excess of what is needed to close the output gap (Chart 34). Foreigners have been net sellers of Treasurys this year. It is equity inflows that have supported the dollar (Chart 35). However, if non-US stock markets begin to outperform, foreign flows into US stocks could reverse. Chart 34The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs Chart 35Equity Inflows Supported The Dollar This Year (I) Chart 35Equity Inflows Supported The Dollar This Year (II) Meanwhile, stronger US growth has pushed long-term real interest rate differentials only modestly in favor of the US. At the short end of the curve, real rate differentials have actually widened against the US since the start of the year, reflecting rising US inflation expectations and the Fed’s determination to keep rates near zero for an extended period of time (Chart 36). Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) On balance, while the dollar could strengthen a bit more over the next month or so, the greenback will weaken over a 12-month horizon. Chester Ntonifor, BCA’s chief currency strategist, expects the dollar to fall the most against the Norwegian krone, Swedish krona, Australian dollar, and British pound over a 12-month horizon. In the EM space, stronger global growth will disproportionately benefit the Mexican peso, Chilean peso, Colombian peso, South African rand, Czech koruna, Indonesian rupiah, Korean won, and Singapore dollar. Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Consistent with our equity views, a weaker dollar would be good news for cyclical equity sectors, non-US stock markets, and value stocks (Chart 37). E. Commodities Favorable Outlook For Commodities Strong global growth against a backdrop of tight supply should sustain momentum in the commodity complex over the next 12-to-18 months. Capital investment in the oil and gas sector has fallen by more than 50% since 2014 (Chart 38). BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects annual growth in crude oil demand to outstrip supply over the remainder of this year (Chart 39). Chart 38Oil & Gas Capex Collapses In COVID-19’s Wake Chart 39Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Chart 40). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of annual copper production. Chart 40ACopper Will Be In Physical Deficit... Chart 40B...As Will Aluminum China’s Commodity Demand Will Remain Strong Chart 41China Keeps Buying More And More Commodities Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 41). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Chart 8Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Chart 11Germany Puts Multilateralism To The Test Chart 12UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues see Danny Crichton, Chris Miller, and Jordan Schneider, "Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors," Foreign Policy Research Institute, March 2021, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar

Dear Client, Dhaval Joshi has started publishing the new BCA Research Counterpoint product, in which he will continue to apply his unique process to dig up original investment opportunities around the globe. I trust many of you will continue to read Dhaval’s excellent and thought-provoking work. I also hope to keep your readership as I take the helm of the European Investment Strategy product, where I will apply BCA’s time-tested method which emphasizes analysis of global liquidity and economic trends to forecast European market outcomes. Thank you for your continued trust and support. Best regards, Mathieu Savary   Highlights The Eurozone’s economy lags the US’s because of weakness in the service sector. Poor vaccine rollouts and tighter fiscal policy explain this bifurcated outcome. Even though Europe will continue to trail the US this year, the summer period will see a sharp European recovery. Investors can take advantage of this rebound by buying the cyclical equities that have lagged during last year’s rally. Favor the French, Italian and Spanish equity markets over the German and Dutch markets. The Bank of England does not need to fight rising Gilt yields; favor the pound over the euro as the UK-German spread widens. The Norges Bank will be the first G-10 central bank to lift rates, which will hurt EUR/NOK. Fade any hawkish noise coming from the German election season. Feature The service sector constitutes the biggest drag on the Eurozone’s economy, which will cause European growth to trail that of the US further. The euro area’s fundamental problem is that it lags the US significantly on both vaccination and fiscal stimulus fronts. Nonetheless, by the summer, the European service sector will start catching up, which will favor a basket of sectors exposed to the economic re-opening that have lagged until now. The Service Sector Remains Under The Weather The consensus is correct to expect European growth to lag that of the US in 2021, even if the extent of the shortfall does not hit the 4% currently penciled in by Bloomberg. Chart 1The Service Sector Is the Problem Unlike normal business cycles, the service sector is now Europe’s biggest handicap, while the manufacturing sector is performing in line with that of the US (Chart 1, top panel). On both sides of the Atlantic, industrial activity has benefited from the same set of positives in recent quarters. Goods purchases were the only outlet for pent-up demand built up in the first and second quarter of 2020. Extraordinarily accommodative global liquidity conditions and record-low interest rates boosted spending on big-ticket items, especially in light of the housing boom that has engulfed the globe. Finally, China’s rapid recovery fueled a swift rebound in the demand for natural resources, autos and machinery that benefited manufacturers the world over. Service activity did not enjoy a similar unified tailwind. Consequently, while the US Services PMI stands at a seven-year high, the Eurozone’s lingers at 45.7, in contraction territory (Chart 1, middle panel). The weaker confidence of European households sheds light on this bifurcated performance (Chart 1, bottom panel). Health and fiscal policies are the main headwinds in the Eurozone that have hurt its service sector and hampered the mood of its households, at least compared to the US. With regard to health policy, the poor vaccination rates on the European continent create the greatest problem. The vaccination effort has only reached 11.8, 11.1, 11.9 and 12.5 doses per 100 person in Germany, France, Italy and Spain respectively. In the US and the UK, authorities have already delivered more than 30 doses per 100 person (Chart 2). As a result, while infection and death per capita are rapidly declining in the US and in the UK, mortality is once again rising in France as well as in Italy and caseloads are increasing there and in Germany. Moreover, hospitalization rates and ICU usage in France, Germany, Italy or Portugal are once again trending up, and in some cases they are hitting threatening levels for the healthcare system. In response to these COVID-19 dynamics, governments in many major Eurozone countries are resorting to the re-imposition of restrictions. Italy has announced new lockdowns in half of its 20 regions while France just entered its third lockdown over the weekend. By contrast, the stringency of restrictions is set to ease in the UK and the US. In the US, limitations were already imposed or followed more laxly relative to the euro area (depending on the state) and mobility was improving (Chart 3). Chart 2Slow Vaccination In The Eurozone Chart 3The Stringency Of Lockdowns Matter Despite the lower mobility created by stricter restrictions in the Eurozone, the US government has opened the fiscal tap much more aggressively than European governments (Chart 4). Since the beginning of the crisis, the US fiscal help has reached 25% of GDP, while in Italy, Germany, France or Spain the budget deficits have swelled by a more modest 14%, 10%, 9% and 13% of GDP, respectively. True, European governments have also offered credit guarantees totaling EUR3 trillion euros, but these sums only have a very indirect impact on aggregate demand and should mostly be understood as liquidity insurance to prevent a liquidity crisis from morphing into a solvency crisis. Chart 4Tight Fists On The Continent For the remainder of 2021, European fiscal policy is unlikely to be eased compared to the US. BCA Research’s Geopolitical strategy team anticipates the Biden government to add a further $2 trillion dollars of spending by the end of 2021, mostly in the form of long-term and infrastructure outlays, in addition to the $1.9 trillion recently legislated.While the European Union’s NGEU plan is an important step in the integration of European fiscal policy, its generous EUR750 billion envelope will be disbursed over five years. This implies a debt-based fiscal expansion of 1% per annum between 2021 and 2024 (the years of maximum disbursements). Individual state plans are also limited. Bottom Line: The European economy is lagging the US economy because of the inferior performance of its service sector. This disadvantage is the consequence of both a slower vaccine rollout that is negatively impacting mobility and a much more timid fiscal policy. Relief Is On Its Way The Eurozone’s service sector and domestic economic performance is nonetheless set to improve, despite the current health and fiscal policy deficiencies. First, the economy continues to adapt to its new socially distanced form. In the second quarter of 2020, the imposition of lockdowns caused the euro area’s quarterly GDP to collapse by 11%. The contribution to GDP of the retail, wholesale, artistic, entertainment, and hospitality sectors tumbled to -7.3%. In Q4 2020, as European governments were imposing equally stringent lockdowns, quarterly GDP growth fell to -0.1% and the contribution to growth of the same sectors only hit -0.54%. Second, the continental vaccination campaign is progressing. It is easy to worry that it will take a very long time to vaccinate the entire population, but the main reason to impose lockdowns is to preserve capacity in the healthcare system. Thus, the priority is to inoculate 50-year olds and above because they constitute 90% of hospitalizations. Through this aperture, even if the pace of vaccination remains tepid in Europe, the goal to decrease economic restrictions can reasonably be achieved by summer. Moreover, with Pfizer’s logistical issues corrected, the pace of vaccination can accelerate. Concerns remain over the population’s willingness to receive the vaccines, but these issues will fade as well. The current worries surrounding the AstraZeneca vaccines provide an example. The incidence of thromboembolic events is marginally higher than for the general population and the European Medicines Agency deemed the AstraZeneca vaccines safe, especially in light of the human costs of the disease it prevents. As caseloads and mortality rates decline in Israel, the UK and the US, even French elderlies will become more willing to receive their vaccines. Table 1Parsimonious But Constant Fiscal Stimulus… Third, fiscal policy will remain easy. True, European government support is tepid compared to the US, but the continual drip of new policy measures shows that authorities are not intransigent (Table 1). In all likelihood, the various furlough and employment protection schemes implemented since the spring of 2020 are likely to remain in place this year even if lockdowns decrease. Their impact on employment was major and they contributed meaningfully to preserve household income (Chart 5). Finally, COVID-19 is a seasonal illness and summer is on its way in Europe. The experience of 2020, when vaccines and testing were much more limited than they are today, has taught us that in the summer months, this coronavirus spreads much less. Therefore, seasonal patterns will allow a relaxation of social distancing measures. Chart 5Furloughs Played A Crucial Role In this context, service activity in the Eurozone will improve, which will boost GDP. European households, like their US counterparts, have accumulated significant excess savings (Chart 6). Furthermore, global manufacturing activity will remain robust, which will support employment and household income in the Eurozone. Hence, consumer confidence will improve and some of the EUR300 billion in excess savings will make its way into the economy. The service sector should be the prime beneficiary of this money because households have already fulfilled a large proportion of their pent-up demand for goods. What they now want to do is to go out, go to restaurants and spend their income on experiences. The rebound in the contribution to GDP of the retail and recreation sectors will be accretive to job and household income, unleashing a virtuous circle of activity (Chart 7). Chart 6European Are Building Their Nest Egg too Chart 7Services Will Contribute Again to Growth Bottom Line: In 2021, the euro area’s economy will further lag that of the US, but investors should nonetheless expect a robust uptick in service activity this summer. How To Play The Summer Recovery? Chart 8Buy The Laggards / Sell the Leaders Five weeks ago, BCA Research’s US Equity Sector Strategy service designed a strategy to buy the laggards within a basket of sectors that should benefit from the recovery while selling the “back-to-work” stocks that had already priced in that recovery.  This recommendation protects investors against potential hiccups in the re-opening trade and is simple to implement: sell/underweight the pro-cyclical sectors that stand above their February 19 relative peak and buy/overweight those that remain below their relative highs (Chart 8). In the Eurozone context, this strategy involves focusing on the cyclical sectors, and buying/overweighting these cyclical stocks that stand below their pre-COVID high relative to the MSCI benchmark while selling/underweighting those that have punched above this threshold. Chart 9 illustrates the sectors to favor and the ones to avoid using this methodology. In essence, not only should the “laggards” baskets experience a catch up in earnings, but also, the shift in sentiment should prompt a re-rating of relative valuations (Chart 10). Chart 9Who Are the Laggards And the Leaders? This strategy makes sense beyond the COVID-19 dynamics. From a global perspective, the basket of sectors purchased (the laggards”) outperforms the former “leaders” after global bond yields increase (Chart 11, top panel). This relationship reflects the heavy representation of financials in the “laggards” basket while tech and the interest rates-sensitive automobile sector are key constituents of the “leaders” basket. Additionally, the former “leaders” are more exposed to the Chinese business cycle than the “laggards". Chart 10Relative Valuations will Adjust Chart 11Macro Forces Favor The Laggards over the Leaders The deceleration in the Chinese economy is a problem for the “leaders” relative performance (Chart 11, bottom panel). China’s credit impulse has rolled over as Beijing aims to prevent excess speculation in the real estate sector. Moreover, a regulatory tightening is taking place in the Middle Kingdom, which will further slow its economy. Already, the new orders-to-inventories ratio from the NBS PMI reflects the downside risk for the Chinese economy, which highlights the threat to the previous high-flying leaders. A strategy that favors the former “laggards” at the expense of the previous “leaders” also has implications for geographical allocation within euro area equities. As Table 2 shows, Italy, France and Spain over represent the “laggards” in their national benchmarks while the Netherlands and Germany overweight the “leaders”. On a net basis, the tech-heavy Netherlands is the country to avoid, with a 27% relative underweight for the “laggards”, while Spain and Italy should be favored, with their 24% and 22% overweight in the “laggards” relative to the “leaders”. Spain and Italy in particular will also benefit from a further narrowing in sovereign spreads that will boost the performance of their financial sector while the re-opening of trade continues. Additionally, investors should favor France at the expense of Germany. Table 2France, Italy, and Spain Over The Netherlands And Germany Bottom Line: The economic re-opening favors the Eurozone cyclicals that still trade below their February 19 2020 relative highs as the expense of those cyclicals that have already overtaken their pre-COVID peaks. This means buying/overweighting the Banks, Insurance, Energy and Aerospace & Defense sectors at the expense of the IT, Automobiles and Building products sectors. It also implies a preference for Italian and Spanish equities, especially relative to Dutch equities. Country Focus: The BoE Follows the Fed, Not The ECB Last Thursday, the Bank of England followed in the Fed’s footprints, not the ECB’s. The BoE refrained from adding to its asset purchases, even if this year, 10-year Gilt yields are rising in line with the Treasuries and rapidly outpacing Bund yields. However, the BoE remains committed to keeping short rates at record lows and it keeps the window open for rate cuts if economic conditions ever warrant it. We agree with the Bank of England that the UK’s economic outlook has improved in recent months. The extension of both the furlough schemes and tax holidays, along with the rapid pace of vaccination in the British Islands point to robust growth in the coming quarters. Nonetheless, the picture is not without blemish. Specifically, the UK’s exports to the EU are collapsing in wake of Brexit. Moreover, the pace of vaccination in the UK is set to slow a bit over the coming months. These risks to the outlook are unlikely to topple the economy, because the vigor of the UK’s housing market is an important support to domestic demand. While the UK’s labor market remains frail, the strength of the RICS housing survey suggests that real wages will stay well bid (Chart 12). The increase in household income will cause consumption to accelerate sharply once lockdowns are eased. This could accentuate inflationary pressures this year, and cause inflation over the next few years to trend higher relative to the euro area. Chart 12UK Real Wages Have Upside With this economic backdrop, the market’s pricing of the SONIA curve is appropriate. Over the past month, the OIS curve has steepened significantly (Chart 13). The BoE is comfortable with that pricing and considers the back up in interest rates to be reflective of stronger growth and not constraining of activity. In fact, financial conditions are roughly unchanged since the MPC’s last meeting, which highlights that rising risk asset prices have compensated for an appreciating pound and rising gilt yields. Chart 13SONIA Is Climbing Up, And The BoE Is Fine With It Bottom Line: The SONIA curve will continue to shift higher relative to the EONIA curve. Consequently, the spread between Gilt and Bund yields will widen further and EUR/GBP will depreciate more over the coming six to nine months, especially because the pound keeps trading at a discount. Moreover, thanks to their domestic focus and lower sensitivity to the pound, UK mid-cap and small-cap stocks will outperform the FTSE-100. Country Focus: Norges Bank, First Out Of The Gate Chart 14The Norges Bank Will Raise Rates First Last Thursday, Governor Øystein Olsen indicated that the Norges Bank would increase interest rates from zero later this year, which validates the message of the Norwegian swap curve. Looking at economic fundamentals, investors should not bet against this outcome. BCA’s Central Bank Monitor confirms that the Norges Bank will be the first central bank in the West to lift interest rates (Chart 14). It is the only one of our Monitors in “Tight Money Required” territory. The message from our Norges Bank Monitor reflects the prompt recovery of the Norwegian economy. Thanks to rebounding Brent prices and rapidly expanding production at the new Johan Sverdrup oil field (the largest in the North Sea), Norwegian nominal exports are growing at a double-digit pace. Meanwhile Norwegian retail sales are increasing at a 16% annual rate. Beyond some near-term COVID worries, consumer spending will remain robust because the strong employment component of the PMI points to solid job gains and a rapidly rising consumer confidence. Finally, Norwegian inflation is already above the central bank’s target of 2%, with core CPI at 2.05% and headline inflation at 3.3%. Chart 15A Weaker EUR/NOK ahead Thanks to Norway’s economic performance, the krone remains one of the favorite currencies of BCA’s Foreign Exchange Strategy service.  The global economic environment creates additional tailwind for the NOK. A continued global economic recovery will allow oil prices to rise further on a 12- to 18-month basis, which should lead to a weaker EUR/NOK (Chart 15). In a similar vein, the NOK is particularly sensitive to the USD dollar’s fluctuations. As a result, BCA’s negative cyclical stance toward the USD will create an important support for the NOK, even if the greenback’s countertrend bounce could last another quarter or so. Finally, along with the SEK, the NOK is the cheapest pro-cyclical currency in the G10, trading at a 5% discount to its fair value. Thus, the Norwegian krone should benefit greatly from continued risk taking this year. Bottom Line: The Norwegian krone remains one of the most attractive currencies in the world. The status of the Norges Bank as the front-runner to lift rates this year only amplifies the NOK’s appeal. A Few Words On Germany’s State Elections Chart 16German Party Polling The defeat of Angela Merkel’s CDU party in the states of Baden-Wurttemberg and Rhineland-Palatinate highlights that the German electorate is moving slowly to the left. According to BCA’s Geopolitical Strategy Service, it is too early to tell whether a left-wing coalition will take power in Germany this fall. However, the marginal shift toward the SPD and the Green Party indicates that even the CDU will have to listen to the median voter’s demands (Chart 16).  Practically, this means that German politics will push for more European integration and that ultimately, more fiscal stimulus will materialize in Europe over the coming years. As a result, investors should fade any hit to the euro or European assets caused by hawkish sounds made by CDU potential leaders during the campaign for the September federal election.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Closed Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance  

Highlights The latest “dot plot” from the Fed reaffirmed the FOMC’s intention to keep rates near zero for at least the next two years, despite evidence that the US economy will recover from the pandemic much faster than expected. The Fed’s reluctance to telegraph any rate hikes stems in part from its conviction that the neutral rate of interest has declined. A lower neutral rate implies that monetary policy may not be as accommodative as widely believed. Whereas Fed officials have argued that the neutral rate has fallen due to structural factors outside their control, critics insist that the Fed’s own actions have painted it into a corner.  By cutting rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble. Moreover, low rates have encouraged governments and the private sector to take on more debt. All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. While we disagree with the view that easier monetary policy has made things worse, we do agree that elevated asset prices and high debt levels limit the Fed’s room for maneuver. In this week’s report, we contend that the low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation starting by the middle of this decade. Growth Dots Up, Rate Dots Not The FOMC released its latest Summary of Economic Projections (aka the “dot plot”) this week. As widely anticipated, the Fed upgraded its view on growth following the passage of the $1.9 trillion American Rescue Plan Act. The Fed now expects real GDP to rise by 6.5% in the fourth quarter of 2021 from a year ago, up from its December 2020 estimate of 4.2%. The Fed also sees the unemployment rate falling to 4.5% by the fourth quarter of this year. Back in December, the Fed thought the unemployment rate would end this year at 5% (Chart 1). Chart 1The Fed Sees Faster Recovery, Same Rate Path Chart 2The Fed Has Been Lowering Its Estimate Of The Neutral Rate The Fed’s unemployment rate projection of 3.9% for 2022 is slightly below the “longer run” estimate of 4.0%. This suggests that the Fed believes the US will have reached full employment by the end of next year. Yet, despite the Fed’s sanguine view on the pace of the economic recovery, the median dot for the expected fed funds rate in 2023 remained at 0.1% (although seven members did pencil in a hike for that year, up from five last December). The median “longer run” dot stayed at 2.5%, with not a single Fed member putting in an estimate above 3%. The Fed regards this longer-run dot as its estimate of the neutral rate of interest – the interest rate consistent with full employment and stable inflation. When the Fed introduced the “dots” back in early 2012, its estimate of the neutral rate stood at 4.3%. It has been trending lower ever since (Chart 2). Explanations For The Falling Neutral Rate What accounts for the steady decline in the Fed’s estimate of the neutral rate in recent years? Fed officials have generally argued that structural forces have dragged down the equilibrium interest rate for the economy. These forces include slower trend growth, an aging population, the shift to a capital-lite economy, high levels of overseas savings, and as we recently discussed, increased income inequality. There is another interpretation, however. Rather than casting the Fed as a helpless observer responding to structural forces beyond its control, some commentators have argued that the Fed’s own actions explain why rates are so chronically low today. By cutting interest rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble, stretching from equities to commercial real estate to cryptocurrencies. Moreover, low rates have encouraged governments and the private sector to take on more debt. Chart 3The Correlation Between Swings In Mortgage Rates And Housing Activity All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. The Fed Is Not The Culprit It is a provocative argument, but is the Fed really to blame? For the most part, the answer is “’no.” To see why, consider the counterfactual: Suppose the Fed did not cut rates. If rates had stayed elevated, the recovery in the cyclical sectors of the economy following the Global Financial Crisis would have been even slower. Housing, in particular, would have remained in the doldrums. Chart 3 shows that there is a strong correlation between housing activity and the 30-year mortgage rate. Lower home prices would have reduced spending via the wealth effect channel, while making it more difficult for banks to recapitalize their balance sheets. In addition, relatively high US rates would have put upward pressure on the dollar, leading to a larger trade deficit (Chart 4). All of this would have reduced aggregate demand. Chart 4The Dollar And The Trade Balance Chart 5Rising Labor Share Of Income Occurring Alongside Labor Market Tightening The share of national income flowing to workers tends to rise when the labor market tightens (Chart 5). A chronic shortfall in aggregate demand would have exacerbated income inequality. Since the poor spend more of every dollar of disposable income than the rich, this would have further dampened overall spending. The Fed has been like a doctor administering a life-saving medicine that comes with some notable side effects. These side effects include increased sensitivity of asset prices to changes in interest rates.1 They also include higher debt levels, at least in those sectors of the economy that had the ability to lever up in response to lower interest rates. Side Effect Triage How dangerous are these side effects? To the extent that today’s low policy rates stem from the fact that structural forces have depressed the neutral rate of interest, they are not especially dangerous at the moment. Yes, debt-servicing costs would balloon, and asset prices would tumble, if the Fed raised rates significantly. However, there’s no reason for the Fed to do that in a setting where the neutral rate is very low. The problem is that the neutral rate may rise over time. Baby boomers are leaving the labor force en masse. They accumulated a lot of wealth while working. According to the Federal Reserve, they currently own more than half of all US wealth (Chart 6). In fact, Americans over the age of 55 controlled 70% of household wealth as of the third quarter of 2020, up from 54% in 1989. As baby boomers retire, their consumption will no longer be backed by income. The resulting depletion of savings will push up the equilibrium rate of interest. Chart 6Baby Boomers Have Accumulated A Lot Of Wealth While US fiscal policy will tighten next year, it will remain highly pro-cyclical by historic standards. BCA’s geopolitical strategists expect Congress to pass a $4 trillion spending bill this fall focusing on infrastructure, health care, and clean energy. They anticipate that only half of the bill will be financed through higher taxes. Big budget deficits will drain private-sector savings. There Will Be Political Pressure To Keep Rates Low Debt is not a major problem for governments when the interest rate they pay is below the growth rate of the economy. As we have discussed before, when trend GDP growth exceeds the borrowing rate, the more debt a government carries, the more fiscal support it can provide without putting the debt-to-GDP ratio on a runaway trajectory. If interest rates were to rise meaningfully, however, what had previously been a virtuous fiscal circle would become a vicious one. Needless to say, governments would resist such an outcome. Faced with the prospect of having to reallocate tax revenue from social programs to bondholders, politicians would put political pressure on central banks to refrain from raising rates. Central banks would probably oblige, at least initially. By keeping interest rates below their equilibrium level, central banks could engineer higher inflation – something they have been striving to do for quite some time. Higher inflation, in turn, could pave the way for an exit from the low interest-rate trap. Rising prices would lift nominal GDP, thereby reducing the debt-to-GDP ratio. As inflation rose, real rates would fall. This would provide relief to overextended private-sector borrowers. Once enough debt had been inflated away, central banks could bring interest rates to their equilibrium level. In the end, bondholders would suffer while borrowers would prosper. This leads us to our key macroeconomic conclusion: Today’s low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation. Investment Implications Equities face some near-term risks stemming from the recent rise in bond yields. Nevertheless, as we have argued in past reports, stocks will shrug off their losses provided that bond yields do not rise to a level that chokes off economic growth. With the Fed still on hold, we do not expect that to happen anytime soon. As such, our best bet is that the Goldilocks environment for risk assets – where growth is strong, inflation is contained, and monetary policy is accommodative – will last another two years. Investors operating on a 12-month horizon should continue to favor stocks over bonds. Within the fixed-income category, investors should overweight spread product relative to safer government bonds. Value stocks will lead the equity market higher over the next 12 months. The pandemic benefited growth names, especially in the tech realm. The cessation of lockdown measures will favor value names. Not only is value still exceptionally cheap in relation to growth, but traditional value sectors such as banks and energy companies have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 7). Chart 7 Earnings Revisions And Valuations Favor Value Stocks (I) Chart 7Earnings Revisions And Valuations Favor Value Stocks (II) Recent upgrades to economic growth forecasts have favored the US, which could help the dollar in the near term. Nevertheless, we expect the greenback to fall modestly over a 12-month horizon. The US trade deficit has ballooned in recent quarters, while the dollar remains overvalued on a purchasing power parity basis (Chart 8). Despite improving US growth prospects, real yield differentials have not moved significantly in favor of the dollar (Chart 9). Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (I) Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (II) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (I) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (II) Moreover, the growth outlook outside the US should improve later this year as more countries ramp up their vaccination campaigns. US growth should also come down from its highs due to the expiration of various stimulus measures. Meanwhile, China will continue to stimulate its economy, albeit at a slower pace. Jing Sima, BCA’s chief China strategist, expects the rate of credit expansion to fall by only 2-to-3 percentage points in 2021. The general government deficit should remain broadly stable at 8% of GDP this year, ensuring adequate fiscal support for growth. A strong Chinese economy will bolster the RMB and other EM currencies. Looking further ahead, the cyclical bull market in stocks will end when inflation rises so high that central banks are forced to tighten monetary policy. While this is not a near-term risk, it is a major danger for the middle of the decade and beyond. As we discussed last week, inflation is often slow to rise in response to an overheated economy, but when it does rise, it can do so precipitously. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios while favoring inflation-protected securities over nominal bonds. In addition to gold, they should own some property. The best inflation hedge is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 For example, suppose the earnings yield is 4% – as it approximately is now for global equities – and the real bond yield is zero, implying an equity risk premium (ERP) of 4%. A one percentage-point increase in real bond yields would require that stock prices fall by 20% in order to keep the ERP unchanged (e.g., the earnings yield would have to rise from 4/100=4% to 4/80=5%). In contrast, if the earnings yield were initially 7% and the real bond yield were 3%, stock prices would need to fall by only 12.5%, taking the earnings yield from 7/100=7% to 7/87.5=8%.   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores