Economy

Highlights Inflation is on everyone’s mind, … : Inflation has been a hot topic in our meetings with clients and in internal BCA discussions, but it has lately broken out among businesses and the general public. … but investors are mainly concerned with what it means for markets, … : When clients ask if and when inflation could become a problem, they really want to know if and when they should be repositioning their portfolios to prepare for it. … which ultimately brings the discussion back to the Fed: Inflation sensitivities vary among (and within) asset classes, but risk assets as a whole fare much worse when monetary policy settings are tight than when they are easy. If rising inflation drives the Fed to impose restrictive monetary policy, it will bring the curtain down on the equity bull market. Feature Inflation has been a hot topic with clients, for the internet-equipped public (Chart 1) and within BCA, where our latest monthly view meeting was entirely devoted to it. Client questions have addressed three broad themes: Chart 1Trending What constitutes too much inflation? How will you know too much inflation is on the way? How soon could too much inflation arrive? Economists have yet to establish exactly where inflation comes from and their attempts to build models that anticipate it have been woefully unsuccessful. The problem may be that prices are set at the micro level by a confluence of innumerable individual interactions. Just as Hayek pointed out that no top-down committee could determine how to allocate resources efficiently without the signals provided by prices, it’s fiendishly difficult to try to divine their aggregate future direction from macroeconomic inputs. Even if we can’t build an airtight model predicting consumer price moves, however, we can systematically assess several known contributors to inflation to try to gain some advance notice into its movements. Obtaining that advance notice is of great practical significance in the current market environment. In a Goldilocks-and-the-two-tails world where widespread vaccinations have rendered the too-cold left-tail outcome increasingly unlikely, overheating is the only obstacle to the potent-growth/easy-policy backdrop that would be just right for equities and other risk assets over the next twelve months. Troublesome inflation seems to be the only factor that could get the Fed to back off of its pledge to maintain ultra-easy monetary policy for an extended period and we see it as the biggest threat to the equity bull market. We are therefore introducing our inflation checklist and expect to revisit it regularly over the rest of the year and into 2022. It reveals what we’re watching to monitor inflation and how, with some interpretive discretion, we’ll know if it’s poised to break out. It will also allow US Investment Strategy readers to follow along with our thinking in real time. As long as the checklist does not point to a meaningful, persistent move higher in consumer prices, we will likely continue to be constructive on the prospects for financial markets and the economy. Checklist Design Table 1Inflation Checklist Our inflation checklist (Table 1) tracks price pressures in five broad categories: Labor Market Indicators, Price Indexes, Pipeline Pressures, Inflation Expectations and the Fed’s Reaction Function. We do not have a hard-and-fast scale of the categories’ relative importance, but we are especially alert to signals from the labor market and changes in inflation expectations. It will be hard to achieve persistently uncomfortable inflation readings without an upward inflection in the pace of wage growth and we do not see wage growth getting traction until inflation expectations rise enough to push workers to agitate for it. As we have previously stated, we do not think that core US inflation measures can break out of the range that has held them in check for three decades unless workers, households and businesses adopt a new inflation mindset (Chart 2). Chart 2Volcker's Gift We do not have a pre-determined rule for how many X’s it will take to signal that policy-altering inflation is on the way. Nor do we have pre-conceived notions about the various combinations of red flags that would herald the onset of a new inflation regime. The purpose of the checklist is to establish a consistent analytical framework for assessing the future direction of inflation and its impact on monetary policy settings. Interpreting the output of that framework will require judgment and we mean to maintain our flexibility in exercising it. The State Of The Labor Market The Phillips Curve, which posits an inverse relationship between unemployment and inflation, has fallen into disrepute with investors. Even the Fed has distanced itself from it, announcing last summer that it would no longer pursue a strategy of pre-emptively tightening policy when the labor market begins to heat up. Asserting that wage growth is inversely related to the unemployment rate simply applies the law of supply and demand to the labor market, and we have no problem with it, although it should be noted that the relationship is not linear. Wages only reliably rise once unemployment breaks below a minimum threshold level, such as NAIRU, the natural rate of unemployment (Chart 3). Chart 3The Unemployment Gap Matters For Wage Growth With that empirical relationship in mind, the category's components consider the available supply and utilization of labor inputs; demand for labor; and wage growth, which should reveal something about the current supply-demand balance. The 61.7% labor force participation rate remains far short of its 63.4% pre-pandemic level (Chart 4, top panel) while the prime-age employment-to-population ratio remains below its trough level of the two recessions that preceded the global financial crisis (Chart 4, bottom panel), making it clear that labor supply is still constrained. Chart 4A Lot Of Workers Are Still Idle ... Labor demand, on the other hand, is at levels topping the cyclical peaks of the last 20 years, according to the share of small businesses reporting job openings in the NFIB survey (Chart 5, solid line) and job openings as a share of total employment as reported by the Department of Labor’s Job Openings and Labor Turnover Survey (Chart 5, dashed line). One would expect that the combination of raging demand and constrained supply to lead to higher wages, yet the top wage measures remain quiet (Chart 6). We expect they will until the prime-age employment-to-population ratio starts to make a run at recovering its pre-pandemic level (Chart 7). Chart 5... Even Though Employers Are Looking For Help Chart 6Wage Growth Remains Subdued Chart 7The Labor Market Still Has A Lot Of Slack The bottom line is that the labor market is starkly bifurcated as vividly illustrated by the Atlanta Fed’s Labor Market Distributions spider chart (Chart 8). On the demand dimensions on the right side of the chart, the labor market is far ahead of where it was at the end of the last two expansions, but far behind on the supply dimensions at the top and bottom left and wages in the middle left. For now, we tick only the Labor Demand box, as it is the only element of the labor market that is back to full health. We expect that shadow supply, which will likely be released in earnest upon next term’s return of in-person instruction in schools across the country and the expiration of unusually generous unemployment insurance benefits, will keep wages from rising much higher until it is fully absorbed. Chart 8A Tale Of Two Markets Price Indexes The Fed’s preferred core PCE index remains in check, along with the headline PCE index (Chart 9, top panel), but the more widely followed CPI surprised to the upside in April (Chart 9, bottom panel), especially in month-over-month terms, with the headline index rising 0.8% and the core index rising 0.9% for its largest gain in 39 years. Last week’s report dove into the details of the core CPI print and concluded that it was driven by extreme outliers in a handful of categories that are unlikely to be sustained.1 The magnitude of the upside surprise nonetheless leaves us no choice but to check the Marquee Indexes box until the sequential increases settle down. Chart 9CPI Took Off In April The message from more refined measures like trimmed-mean CPI and PCE is more encouraging (Chart 10). Trimmed-mean indexes are akin to the Olympic judging method in which the top and bottom scores are discarded, and their proponents argue that they provide a truer measure of core inflation than the static series which exclude every food and energy category every month. The trimmed-mean CPI and PCE series are well behaved and suggest that the inflation genie has not yet gotten out of the bottle. Chart 10Outliers May Be Skewing The Core Indexes ... Pipeline Pressures Price increases across the commodity complex have drawn inflation watchers’ attention. Prices at the pump loom large in consumers’ perceptions of inflation and commodities are inputs in a range of manufactured goods; if manufacturers are able to pass price increases onto end users, commodity price increases may find their way into end-product prices. The BCA pipeline inflation indicator rolls the CRB raw industrials index, the ISM survey’s prices paid and supplier delivery time components, overtime hours worked and capacity utilization into a single measure that has moved in step with CPI. It is currently at its highest level in two decades (Chart 11). Chart 11... But Bottlenecks Are Inflicting Near-Term Upward Pressure Exchange rate moves are not as important for US inflation as they are in economies that are more reliant on trade, but they still matter at the margin. When the dollar weakens, the price of imports rises and when it strengthens, the price of imports falls. Trade-weighted indexes are our go-to series for gauging the dollar’s course (Chart 12, top panel), but the DXY index draws a lot of attention from market professionals and it is currently testing a multi-year technical support level (Chart 12, bottom panel). A break below 90 would presage a further fall and may push inflation expectations higher. Chart 12A Weaker Dollar Could Push US Import Prices Higher ... Services inflation is mainly a domestic phenomenon, but goods prices are globally determined. Inflation measures in major international economies can therefore provide some insight into the path of goods prices and the path of US inflation at the margin. Headline and core consumer prices in the Eurozone have yet to stir from their slumber (Chart 13, top panel) while consumer prices in China briefly deflated (Chart 13, bottom panel). The rest of the world is not yet exerting upward pressure on US consumer prices. Chart 13... But There Isn't Much Inflationary Pressure Outside The US Inflation Expectations Chart 14Investors Vote For Transitory Expectations inform behavior. If a widespread belief that troublesome inflation is going to return takes hold, individual workers and unions will demand higher wages to maintain their purchasing power, businesses up and down the supply chain will insist on price hikes to protect their margins and consumers may accelerate their big-ticket purchase decisions. Each of these actions adds fuel to the fire, and if economic participants come to believe that a new inflation regime has arrived, it could initiate a self-reinforcing dynamic in which higher prices beget higher prices. Think of it as the flip side of the deflation mindset that has left Japan with relentless disinflation in consumer prices and a relative plunge in asset prices. We are monitoring the inflation expectations curve very closely with the aim of detecting the arrival of a new inflation mindset. If the curve were to shift out – inflation expectations were higher across all time periods – and steepen, with inflation expectations rising across the entire time horizon, participants in the real economy might be on the cusp of changing their behavior to align with expectations. For now, we are encouraged that the inflation expectations curves as derived from the difference in TIPS and nominal Treasury yields (Chart 14, top two panels), and from the CPI swaps market (Chart 14, bottom two panels) suggest that investors agree that inflation pressures are likely to dissipate. We come to that conclusion from the fact that the 2-to-5-year and 5-to-10-year segments of the curve are inverted, which is to say that investors expect near-term inflation will exceed longer-term inflation. Inversion in both segments shows that investors expect a steady decline, with the inflation rate over the next two years exceeding the inflation rate over the next five years and the inflation rate over the next five years exceeding the inflation rate over the next ten years. We place greater reliance on market-determined measures of inflation expectations than survey measures, but we are monitoring a range of consumer and business surveys. The University of Michigan’s consumer sentiment survey shows that households also expect that near-term inflation pressures will not persist. Its respondents see inflation soaring over the next twelve months (Chart 15, top panel) but rising much more modestly over the next five years (Chart 15, bottom panel). Chart 15Households Also Think Acute Inflation Pressures Will Be Short Lived Fed Reaction Function The investment implications of higher inflation come down to how the Fed reacts to it. For now, the Fed is sticking to its pledge that it has reduced its propensity to tighten policy. It remains outwardly committed to pursuing an average inflation target and to eschewing proactive policy tightening when the labor market appears to be firming. Though we expect that markets will periodically test the Fed when inflation seems to be gathering momentum, we do not yet see any reason to doubt its resolve. We will only check either of the Fed boxes in the event that Fed speakers begin to telegraph a change of direction or if the summary of economic projections (“the dots”) indicates that the bias toward accommodative policy is shifting. We see that bias as nearly fixed in the near term, given that the Fed has gone to considerable lengths to outline its policy goals for participants in the financial markets and the economy. It is not etched in stone, but we don’t foresee a material change in the next few months. Until we do, or until we become convinced that the Fed has allowed itself to get helplessly behind the inflation curve, we expect to stick to our recommendation to overweight risk assets at the expense of Treasuries over the twelve-month cyclical timeframe.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the May 17, 2021 US Investment Strategy report, "The Data That Cried Wolf," available at www.bcaresearch.com.

Dear client, In addition to this weekly report, we also sent you a Special Report on cryptocurrencies, authored by my colleagues Guy Russell and Matt Gertken. The conclusion is that government authorities are likely to lean against the proliferation of cryptocurrencies, something we suspected in our most recent report on the topic. Regards, Chester Highlights Net foreign inflows into US assets probably peaked in March. Meanwhile, there are strong reasons to believe outflows from US securities will accelerate in the coming months. As such, the 12-18-month outlook for the US dollar remains negative. Cryptocurrencies are correcting sharply amidst a crackdown in China, a risk we warned investors about in our Special Report last month. We are increasingly favoring the yen. Lower the limit-sell on USD/JPY to 109. Hold long CHF/NZD positions recommended last week. Feature Chart I-1Current Account Deficit = Capital Account Surplus The US runs a sizeable trade deficit. As such, it must import capital to finance this deficit (Chart I-1). Over the last year, this has been driven by equity and agency bond purchases by foreigners. However, we might be at the apex of a shift, where foreign appetite for US securities starts a meaningful decline. Financing The US Deficit TIC data is usually a lagging indicator for FX markets, but still holds valuable insights into foreign appetite for US assets. On this front, the March data was particularly instructive: There were strong inflows into US Treasury notes and bonds, to the tune of almost $120 bn. This was the greatest driver of monthly inflows. This was also the largest monthly increase since the global financial crisis. Net inflows into US equities stood at $32.2 bn in March. This is on par with the three-month average, but a sharp deceleration from December inflows of $78.3 bn. Corporate bonds commanded particularly strong inflows in March to the tune of $43.1 bn. It appears that foreign private concerns swapped their agency bond purchases with corporate bonds. US residents repatriated $54.1 bn back home in March. Official concerns were big buyers of long-term US Treasury bonds, but this was offset by a large sale of US T-bills. Net foreign official purchases of overall US securities were just $6.5 bn. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. The question going forward is whether there has been a regime shift in US purchases, specifically the purchase of equities (and agency bonds). And if so, can the purchase of US Treasurys pick up the slack (Chart I-2). Foreign inflows into the US equity market tend to be driven by expected rates of return, either from an expected rerating of the multiple or from profit growth. A rerating of the US equity multiple, relative to the rest of the world, has inversely tracked interest rates (Chart I-3). This is due to the higher weighting of defensive sectors in the US equity market. Concurrently, we showed in a recent report that profit growth on an aggregate level also tends to move in sync with relative economic momentum.1  Chart I-2Equity Inflows Have Financed ##br##The US Deficit Chart I-3Rising Bond Yields Would Curtail Equity Inflows If growth is rotating away from the US, and global bond yields still have upside, this will curtail foreign appetite for US equities. This appears to be the story since March, as non-US bourses have outperformed (Chart I-4). Chart I-4ANon-US Markets Are Bottoming Chart I-4BNon-US Markets Are Bottoming In terms of fixed income flows, the rise in US bond yields towards a peak of circa 180bps in March undoubtedly triggered strong inflows into the US Treasury market. Since then, yields outside the US have been moving somewhat higher, especially in Germany. This should curtail bond inflows, and also fits with a growth rotation away from the US. While foreign central banks were net buyers of US Treasurys in March, the “other reportables” category from the CFTC data show a huge short position in US 10-year futures. Foreign central banks are usually grouped in this category. This will suggest the accumulation of Treasurys should reverse in the coming months (Chart I-5). Chart I-5Did Central Banks Hedge Their March Purchases? A rotation of growth from the US towards other parts of the world would also make it more difficult to finance the US current account deficit. This is because it will compress real interest rate spreads between the US and the rest of the world. From a historical perspective, inflows into US Treasury assets only tend to accelerate when real rates in the US are at least 50-100 bps above that in other G10 economies (Chart I-6). That could explain why despite a positive Treasury-JGB spread of 165 basis points, Japanese investors were very much absent buyers in March (Chart I-7). Chart I-6Real Rate Differentials And Bond Capital Flows Chart I-7The Big Boys Did Not Buy Much Treasurys In March Critical to this view is the outlook for US inflation. On this front, we note the following: First, the output gap in the US should close faster than most other economies, at least according to the OECD (Chart I-8). Ceteris paribus, US inflation should outpace that in other countries in the near term and put downward pressure on real rates. Chart I-8The US Should Generate Higher Inflation Fiscal spending has been more pronounced in the US compared to other countries, which will further fan the inflationary flames. The Fed is the only central bank in the G10 committed to an inflation overshoot. In a nutshell, there is compelling evidence to suggest US inflows peaked in March from both foreign equity and bond investors. Upside surprises in inflation are more likely in the US in the very near term compared to other economies, which will depress real rates. Meanwhile, higher global yields are also a negative for the US equity market. There Is No Alternative Chart I-9A Deep And Liquid Pool Of Treasurys My colleague, Mathieu Savary, has made the case that there is no alternative to US Treasurys. The treasury market is the most liquid and the deepest safe haven pool in the capital market universe (Chart I-9). Ergo, a flight to safety will always bid up Treasurys, as we saw in March 2020. We do agree that Treasurys will continue to act as the world’s safe haven benchmark for now. However, that privilege is fraying at the edges, and it is the marginal changes that matter for dollar investors. Competition for safe haven assets continues to intensify as the narrative switches from 40 years of disinflationary forces to the rising prospect of an inflation overshoot. Inflation is anathema to fiat currencies, including the dollar. For investors, precious metals have been a preferred habitat for anti-fiat holdings. That said, cryptocurrencies are also rising in the ranks as an alternative. In our Special Report2 released a month ago, we suggested government regulation was a huge risk for cryptocurrencies. But more specifically, the degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Since the peak in the DXY index in 2020, the biggest sellers of US Treasurys have been private investors. Cryptocurrencies benefited from this diversification. That has changed since March, which partly explains the big drawdown in crypto prices. In general, you always want to align yourself with strong buyers who are price indiscriminate. Foreign central banks (the biggest holders of US Treasurys) prefer gold as their anti-dollar asset. This puts an solid footing under gold prices, compared to cryptocurrencies or other anti-fiat assets. It is worth noting that competition between the dollar and gold often run in long cycles. In the 1970s, as inflation took hold in the US, the dollar depreciated and gold soared. In the 1980s, the dollar took off and gold fell sharply, as the Federal Reserve was able to bring down inflation. The 1990s were relatively disinflationary, which supported the dollar (Chart I-10). A whiff of rising inflation in the early 2000s hurt the dollar, while the 2010s were characterized by very low inflation, supporting the dollar. More recently, the dollar is weakening as inflationary trends accelerate faster in the US (Chart I-11). Chart I-10The Dollar And Inflation Move Opposite Ways (1) Chart I-11The Dollar And Inflation Move Opposite Ways (2) One of our favorite indicators for gauging ultimate downside in the dollar is the bond-to-gold ratio. The rationale is that the bond-to-gold ratio should capture investor preference at the margin for either US Treasurys or gold. This in turn has been a good measure of investor confidence in the greenback. On this basis, the bond-to-gold ratio (TLT-to-GLD ETF) is breaking down to fresh cycle lows (Chart I-12). This has historically pointed towards a lower US dollar. Chart I-12The Dollar And The Bond-To-Gold Ratio Within precious metals, we like gold but love silver. As such, we are short the gold-to-silver ratio since an entry point of 68. Our bias is that initial support for this ratio is 60. Meanwhile, we also like platinum, and will go long versus palladium at current levels. A Few Other Indicators A few other market developments are pointing to a lower dollar in the coming months. The dollar tends to decline in the second half of the year. This has been true since the 1970s (Chart I-13). Importantly, even during the Paul Volcker years in the 80s when the dollar staged a meaningful rally, it often fell in the second half of the year. The winner in the second half of the year has usually been the Swiss franc and the Japanese yen (Chart I-14).  Chart I-13The Dollar Usually Strengthens In H1 Chart I-14The Dollar Usually Weakens In H2 The OECD leading economic indicators still suggest US growth remains robust relative to the rest of the G10. However, our expectation is that this gap will decrease sharply in the second half of this year. That said, the current reading is a risk to our dollar bearish view (Chart I-15). Chart I-15US Exceptionalism Is A Risk For Dollar Bears Lumber has started to underperform Dr. Copper. Lumber benefits from solid US housing activity, while copper is more tied to global growth and the emerging investment in green technology. As a counter-cyclical currency, the dollar also tends to underperform higher beta currencies when lumber is underperforming copper (Chart I-16). The copper-to-gold ratio has also bottomed, suggesting ample liquidity is now fueling growth (Chart I-17). We suggested last week that the velocity of money across countries was a key variable to watch in getting the dollar call right. So far, the collapse in money velocity is least acute in China, explaining the rise in the copper-to-gold ratio and the improvement in non-US yields compared to the US. Chart I-16Lumber/Copper Prices And The Dollar Chart I-17Copper/Gold Prices And Bond Yields In summary, many cyclical indicators still point to a lower dollar. The key risk to this view is an equity market correction, and/or persistent relative strength in US growth.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Report, "Trading Currencies Using Equity Signals," dated May 7, 2021. 2 Please see Foreign Exchange Special Report, "Will Cryptocurrencies Displace Fiat," dated April 23, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand.  This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption.  We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year.  This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023.  Chart 3US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Chart 7Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 Chart 11     Footnotes 1     Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights The reason to own stocks is not profit growth. The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will be lacklustre, at best. The reason to own stocks is that the ultimate low in the T-bond yield is yet to come. This ultimate low in the T-bond yield will define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks… …and tilt towards long-duration growth sectors and growth-heavy stock markets such as the S&P500 that will benefit most from the final collapse in yields. The correction in DRAM, corn, and lumber prices suggests that the recent mania in inflation expectations is about to end. Fractal trade shortlist: copper and tin are fragile, go long T-bonds versus TIPS. Feature Chart of the WeekGlobal Profits Surged During The Credit Boom, But Have Gone Nowhere Since The main reason to own stocks is not what you think. The usual long-term argument to own stocks is based on profit growth – specifically, that an uptrend in profits drives up stock prices. Except that since 2008, this is not true (Chart of the Week and Chart I-2). Profits have barely grown, yet the global stock market has doubled.1 Chart I-2Since The Credit Boom Ended, Global Profits Have Barely Grown As profits have barely grown since 2008, the main reason that the global stock market has doubled is that the valuation paid for those profits has surged. Looking ahead, we expect this to remain the main reason to own stocks. The Reason To Own Stocks Is Not Profit Growth Profits are the product of sales and the profit margin on those sales. During the credit boom of the nineties and noughties, the strong tailwind of credit creation supercharged sales growth. At the same time, the profit margin on those sales trended higher (Chart I-3). Chart I-3Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Hence, in the decade leading up to 2008, global stock market profits surged, outstripping both sales and world GDP. Then the credit boom ended, and profits languished, because: Absent the tailwind from the credit boom, sales growth moderated. The profit margin trended lower. In the post-pandemic years, we expect both trends to persist. The credit boom is not coming back. Furthermore, as the pandemic recession was not protracted, sales are not at a depressed level from which they can play a sharp catch-up, as they did after the 2008 recession and the 2015 emerging markets recession. The structural downtrend in the profit margin will continue. Meanwhile, the structural downtrend in the profit margin will continue. Governments are desperate to mitigate – or at least, contain – the ballooning deficits that have paid for their pandemic stimuluses. Raising corporate taxes from structurally depressed levels is an easy and politically expedient response, as we have already seen from both the Biden administration in the US, and the Johnson administration in the UK. Higher corporate taxes will weigh on structural profit margins (Chart I-4). Chart I-4Corporate Taxes Will Rise From Structurally Depressed Levels The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will continue to be lacklustre, at best. The Reason To Own Stocks Is That The Ultimate High In Valuations Is Yet To Come To repeat, the main reason that the global stock market has doubled since 2008 is that its valuation has surged (Chart I-5). Chart I-5The Main Driver Of The Stock Market Has Been Valuation Expansion In turn, the stock market’s valuation has surged because bond yields have plummeted. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The main reason that the global stock market has doubled since 2008 is that its valuation has surged. Through 2012-13, the decline in the Italian BTP yield, by signifying the fading of euro break-up risk, boosted stock valuations. In more recent years though, it has been the US T-bond yield that has been more influential in driving the global stock market’s valuation (Chart I-6). Chart I-6The Stock Market's Valuation Expansion Is Due To Lower Bond Yields But the crucial point to grasp is that the relationship between the declining bond yield and stock market valuation becomes exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but considerably more downside. This extra riskiness of bonds means that investors demand a diminishing risk premium on equities versus bonds. So, as bond yields decline, the required return on equities – which equals the bond yield plus the risk premium – collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-7 and Chart I-8 demonstrate this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market’s valuation is on the linear right scale. The logarithmic versus linear scale visually demonstrates that at a lower bond yield, a given change in the bond yield has a much greater impact on the stock market’s valuation. Chart I-7The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential Chart I-8When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge Specifically, if the 30-year yield in the US reached the recent low achieved in the UK, it would boost the stock market’s valuation by nearly 50 percent. We fully expect this to happen at some point in the coming years because of The Shock Theory Of Bond Yields which we introduced in last week’s report. In a nutshell, the shock theory of bond yields states that each successive deflationary shock takes the bond yield to a lower structural level, until it can go no lower. Although it is impossible to predict the timing and nature of individual shocks such as the pandemic, it is easy to predict the statistical distribution of shocks. On this basis, the likelihood of a net deflationary shock is 50 percent within the next three years, and 81 percent within the next five years. Whatever that deflationary shock is, and whenever it arrives, it will mark the ultimate low in the 30-year T-bond yield – at a level close to the recent low in the UK. This ultimate low in the T-bond yield will also define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks. And tilt towards long-duration growth sectors that will benefit most from the final collapse in yields. Growth sectors and growth-heavy stock markets such as the S&P500 will continue to outperform, as they have done consistently since 2008. The Inflation Bubble Is Bursting   The last couple of months has seen a mania in inflation expectations. As industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities led to understandable spikes in their prices. These commodity price increases then unleashed fears about inflation. As investors sought inflation hedges, it drove up commodity prices more broadly … which added to the inflation fears…which added further fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The inflation bubble is bursting. But now it seems that the indiscriminate rally is over. DRAM prices have rolled over, belying the thesis that there is widespread shortage in semiconductors (Chart I-9). More spectacularly in the past week, the corn price has tumbled by 12 percent while the lumber price has slumped by 25 percent (Chart I-10). Chart I-9DRAM Prices Have ##br##Rolled Over Chart I-10Lumber Prices Are Correcting, Will Other Commodities Follow? Given that the commodity rally was indiscriminate, there is a danger that any correction will spread into other commodities like the industrial metals, copper and tin – especially as their fractal structures are at a level of fragility that has identified previous turning points in 2008, 2011, 2015, 2017 and 2020 (Chart I-11 and Chart I-12). Chart I-11Copper's Fractal Structure Is Fragile Chart I-12Tin's Fractal Structure Is Fragile In any case, the mania in inflation expectations is about to end. An excellent way to play this is to expect compression in the market implied inflation rate in T-bond yields versus TIPS yields (Chart I-13). Chart I-13The Mania In Inflation Expectations Is About To End Hence, this week’s recommended trade is to go long the 10-year T-bond versus the 10-year TIPS, setting a profit target and symmetrical stop-loss at 3.6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  To clarify, Chart 2 shows world stock market earnings per share, both 12-month forward and 12-month trailing. Whereas Charts 1 and 3 show sales and net profits (not per share). 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