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Highlights Geopolitical risk is rising once again after a big drop-off in risk during the pandemic and snapback. The Biden administration faces three critical foreign policy tests: China/Taiwan, Russia/Ukraine, and Israel/Iran. Russia could stage a military incursion into Ukraine that would cause a risk-off event. However, global markets would get over it relatively quickly since a total invasion of all Ukraine is unlikely. Iran is nearing the “breakout” threshold of uranium enrichment which will prompt more Israeli demonstrations of its red line against nuclear weaponization. Iran will retaliate. So far our view is on track that tensions will escalate prior to the resolution of a US-Iran deal by August. Taiwan is the most market relevant of all geopolitical risks – but the South China Sea is another scene of US-China saber-rattling. A crisis here is most important if connected to Taiwan. Go long CAD-RUB and CHF-GBP. Feature Chart 1Traffic In The World’s Most Dire Straits British Prime Minister Harold Macmillan, quoting Sir Winston Churchill, once said, “Jaw-jaw is better than war-war.”1 President Joe Biden would undoubtedly prefer jaw-jaw as he faces three imminent foreign policy tests that raise tail-risks of war: Chinese military intimidation of Taiwan, a Russian military build-up on the Ukrainian border, and Iranian acceleration of its nuclear program. All of these areas are heating up simultaneously and a crisis incident could easily occur, causing a pullback in bond yields and equity markets. One way of illustrating the seriousness of these conflicts is to look at the volume of global trade that goes through the relevant geographic chokepoints: the Taiwan Strait, the Strait of Malacca, the Strait of Hormuz, and the Bosphorus Strait (Chart 1). Oil and petroleum products serve as a proxy for overall traffic. The recent, short-lived blockage of the Suez Canal provides an inkling of the magnitude of disruption that is possible if conflict erupts in one of these global bottlenecks. In this report we review recent developments in Biden’s foreign policy tests. Our views are mostly on track. Investors should prepare tactically for more geopolitical risk to be priced into global financial markets, motivating safe-haven flows and potentially a general equity pullback. Cyclically the bull market will continue, barring the worst-case scenarios. Biden’s Three Foreign Policy Tests Biden’s three foreign policy tests are all intensifying as we go to press: China/Taiwan: China is continuing a high-intensity pace of “combat drills” and live-fire drills around the island of Taiwan.2 The US is sending a diplomatic delegation to Taiwan against Beijing’s wishes and is set to deliver a relatively large arms sale to the island. Yet Washington has sent John Kerry, its “climate czar,” to Beijing to set up a bilateral summit between Presidents Biden and Xi Jinping for Earth Day, in a bid to find common ground. Biden’s overarching review of US China policy is due sometime in May. Russia/Ukraine: Russia has amassed more than 85,000 troops on its border with Ukraine and in Crimea, the largest build-up since it invaded Ukraine in 2014-15. Russia has withdrawn its ambassador to Washington and warned that it will retaliate if the US imposes any new sanctions. The US is doing just that, with new sanctions leveled in response to Russian cyberattacks and election interference, including a block on sales of Russian ruble-denominated sovereign bonds from June. Hence Russian retaliation is looming. Israel/Iran: Shortly after the March 23 election, Israel sabotaged the underground Natanz Fuel Enrichment Plant in Iran, prompting the Iranians to declare that they will retaliate on Israeli soil. They also claim they will now enrich uranium to a 60% level, which pushes them close to the 90%-plus levels needed to make a nuclear device. American and Israeli officials had previously signaled that Iran would reach “breakout” levels of weapons-grade uranium between April and August. Negotiations are underway but the process will be beset by attacks. We have written extensively on the Taiwan dynamic this year as it is the most relevant for global investors. In this report we will update the Russian and Iranian situations first and then proceed to China. Bottom Line: Geopolitical risk is back after a reprieve during the pandemic. The new US administration faces three serious foreign policy tests at once. Financial markets have mostly ignored the rise in tensions but we expect safe-haven assets to catch a bid in the near term. However, we have not yet altered our bullish cyclical view. So far we are still in the realm of “jaw-jaw” rather than “war-war,” as we explain in the rest of this report. Stay Short Russia And EM Europe The return of the Democratic Party to power in Washington has led to an immediate increase in US-Russian tensions. The Biden administration is eschewing a diplomatic reset and instead pursuing great power competition. The US is increasing its arms sales and NATO military drills with Ukraine. It is imposing sanctions over Russian cyberattacks and election interference, including taking a long-awaited step against the purchase of ruble bonds. Washington could also force Germany to cancel the Nord Stream II pipeline. However, there are also mitigating signs. President Biden has offered to hold a bilateral summit with President Vladimir Putin in a third country and the two may meet at his Earth Day summit. The US Navy also called back the USS Donald Cook and USS Roosevelt destroyers from going into the Black Sea, after Moscow warned that any American warships in that sea would be in danger, especially if they go near Crimea. Washington’s new volley of sanctions are not truly tantamount to Russian interference in American elections and they do not include new measures on Nord Stream II. An American move to insist that Germany cancel Nord Stream before construction ends would provoke Russia to retaliate. The purpose of Nord Stream is to bypass Ukraine and cement direct economic ties between Russia and Germany. Germany’s government continues to support the project despite Russia’s build-up on the border with Ukraine and suppression of political dissidents. If the US vetoes the pipeline then it is denying Russia access to legitimate trade and restricting Russia’s export options to the Ukrainian route. If the US simultaneously increases military cooperation with Ukraine then it is implicitly trying to control Russia’s energy access to Europe. Russia will likely retaliate by punishing Ukraine. Russia could take aggressive action in Ukraine or elsewhere regardless of what the US does on Nord Stream or in its Ukraine outreach. Russia is struggling with a weak domestic economy and social unrest. Moscow has a record of foreign adventurism when popular support wanes. Moreover legislative elections loom in September. Thus Russia may have an independent reason to stir up conflict in Ukraine, at least for the next half year, that cannot be deterred. Judging by capabilities, Russia has deployed enough troops to stage a military incursion into the breakaway Donbass region of Ukraine. The Russian army build-up on the border is the largest since 2014 – large enough to put most of Russian-speaking Ukraine at risk. A full-scale Russian invasion of all of Ukraine is unlikely but not impossible. It would be extremely costly both in blood and treasure – not only in occupying a hostile Ukraine but also in unifying the West against Russia, the opposite of what Moscow is trying to accomplish (Chart 2). Moscow will want to avoid this outcome unless the US shuts down Nord Stream or tries to bring Ukraine into NATO. Chart 2Russia’s Constraints Over Ukraine From the market’s point of view, intensified fighting in Ukraine between the government and Russian-backed rebels is status quo. This is inevitable and will not have a major impact on global equities. The invasion of Crimea in 2014 led to a maximum 2% drawdown in the S&P 500. It was the shooting down of Malaysian Airline 17, not Russia’s invasion of Ukraine, that shook up financial markets in 2014. Global equities fell by 2.7%, Eurostoxx 500 by 6.2% and Russian equities by 10.7%. Note that the Russian military did ultimately participate in the fighting in 2014-15, it was not only Russian-backed separatists, so global financial markets can stomach that kind of conflict fairly well as long as it is limited to Ukraine, especially disputed regions, and as long as the US and NATO do not get involved. They are disinclined to fight for Ukraine, leaving it vulnerable. A larger flight to safety would occur if Russia pursued the total conquest of all of Ukraine. This is small probability but high impact. It would cause a major global risk-off because it would raise the risk of a larger war on the continent for the first time since World War II. Russia is obsessed with Ukraine from the point of view of grand strategy and national security and will take at least some military action if it deems it necessary. Investors should be prepared for escalation – though neither Washington nor Moscow has yet taken a fatal step. It is important to watch for any aggressive Ukrainian actions but Ukraine is not the main driver of action. The current situation is reminiscent of that in the Republic of Georgia in 2008, when Russia provoked President Mikhail Saakashvili into taking action against separatists that Russia then used as a pretext for intervening and breaking away Abkhazia and South Ossetia. While Ukrainian President Volodymyr Zelenskiy could be baited into a conflict, it is also true that fear of getting baited could result in hesitation that allows Russia to seize the initiative, as occurred in Ukraine in 2014. So for the Ukrainians it is “damned if you do, damned if you don’t.” Russia’s actions will largely depend on its own interests. So far Russian equities have lagged other emerging market equities and the commodity rally, which may partly reflect elevated political and geopolitical risk (Chart 3). The trend for Russian equities can easily get worse from here. Given Russia’s interest in conflict with the West ahead of the September elections, Russian-Ukrainian tensions could persist for most of this year. A major military campaign becomes more probable after mid-May when the weather improves. Russian currency and assets will remain under pressure. We recommend going long the Canadian dollar relative to the Russian ruble. The ruble will underperform commodity currencies as a whole, including the Mexican peso, if Russia intervenes militarily, judging by the Crimea conflict in 2014 (Chart 4). Meanwhile Canadian and Mexican currencies should benefit from the fact that the US economy is hyper-stimulated and rapidly vaccinating. Chart 3Russia Lagged Commodity Rally Chart 4Favor Loonie And Peso Over Ruble Chart 5Long DM Europe / Short EM Europe We continue to overweight developed Europe and underweight emerging Europe (Chart 5). Poland, Hungary, the Czech Republic, Romania, and the Baltic states will see a risk premium due to current tensions. The Czech Republic faces considerable political uncertainty surrounding its legislative election in October, an opportunity for Russia to interfere or for anti-establishment (albeit pro-EU) parties to rise to power. What would it take for Biden and Putin to de-escalate? The US and NATO could diminish Ukraine relations, downgrade democracy promotion and psychological counter-warfare, and allow Nord Stream to be completed. Russia could reduce its troop presence on the border and lend a helping hand on the Iranian nuclear deal and Afghanistan withdrawal. This is a risk to our view. Bottom Line: Russia and emerging European markets are some of the few truly cheap markets in the emerging market equity universe (Table 1). Yet the current geopolitical context looks to keep them cheap. For now investors should be prepared for the West’s conflict with Russia to escalate in a major way. At minimum we need to know whether the US will halt Nord Stream II’s construction before taking a more bullish view on EM Europe. Table 1Geopolitical Risk Helps Keep Russia And EM Europe Cheap The worst-case scenario of a full-blown Russian conquest of Ukraine has a small probability but cannot be ruled out. Iran Negotiations: First Explosions, Then A Nuclear Deal Israel has not put together a government after its March 23 election, although Prime Minister Benjamin Netanyahu has the opportunity to lead a government again which means no change in national policy so far. Moreover the Israeli public and political establishment are unified in their opposition to Iran’s regional and nuclear ambitions. Immediately after the Iranians inaugurated new centrifuges at the Natanz nuclear facility, on April 11, the Israelis allegedly sabotaged the facility underground facility in an attack that was supposedly not limited to cyber means and that deactivated a range of centrifuges. An Iranian scientist fell into a crater and hurt himself. The Iranians have vowed retaliation on Israeli soil. More fundamentally their politics are shifting in a hardline direction, to be confirmed with the election of a hawkish president in June, which will exacerbate the mutual antagonism. This power transition is a major reason we have identified the inauguration in August as a key deadline for the US to rejoin the 2015 nuclear deal (the Joint Comprehensive Plan of Action). If the Biden administration cannot get it done by that time then a much more dangerous, multi-year negotiation will get underway. The Israeli attack has not stopped negotiations in the short term, however. The second round of talks begins in Vienna as we go to press. The US has also confirmed it will withdraw from Afghanistan on September 11, which says to Iran that Biden is determined to reduce the US’s strategic footprint in the region, reinforcing the US desire for a deal. The Israelis will continue to underscore their red line against the Iranian nuclear and missile programs in the coming months through clandestine attacks. However, they were not able to stop the US from signing a nuclear deal with Iran in 2015 and they are not likely to stop the US today. They are still bound by a fundamental constraint. Israel needs to maintain its alliance with the United States, which ensures its long-term security against both Iran and the Middle East’s general instability (Chart 6). The Iranians will retaliate against Israel, making it likely that this summer will feature tit-for-tat attacks. These could include critical infrastructure. Iran may also continue its campaign against enemies in Iraq and Saudi Arabia, thus triggering unplanned oil outages and pushing up the oil price. A glance at Israeli, Saudi Arabian, and UAE stock markets suggests that global investors have largely ignored the geopolitical risks so far but may be starting to respond to the likely escalation in conflict prior to any US-Iran deal (Chart 7). Chart 6Israel’s Constraints Over Iran The US, Germany, France, Russia, and China are all officially on board with getting the Iranians back into compliance with the deal. A return to compliance would need to be phased with US sanctions relief. The Iranians demand that the US ease sanctions first, since it was the US that unilaterally walked away from the deal and re-imposed sanctions in 2018. Chart 7Saudi, UAE, Israeli Stocks Signal Danger Ultimately Biden is capable of making the first move since the American public shows very little concern about Iran. Biden himself is acting on behalf of a strong consensus in Washington that an Iranian deal is necessary to stabilize the region and enable the US to devote more strategic attention to Asia Pacific. Will Russia and China support the Iranian deal, given their simultaneous conflicts with the United States? As long as the US and Iran are satisfied with returning to the existing deal – which begins to expire in 2025 – there is little need for Russia or China to do anything. However, if Washington wants a better deal, then it will have to make major concessions to Moscow and Beijing. A new and better deal would require years to negotiate. Chart 8Russo-Chinese Cooperation Grows Russia and China supported the original nuclear deal because they saw an opportunity to limit the proliferation of nuclear weapons, which dilutes their own power. A Middle Eastern nuclear arms race is not in their interest. Iran is also a useful strategic partner for Russia and China in the Middle East and they are not averse to seeing Iran’s economy grow stronger in order to perpetuate its regime. They are wagering that liberalization of the Iranian economy will not result in liberalization of its politics – it certainly did not in the case of Russia or China – and therefore they will still have an ally but it will be more economically sound and influential. The Russo-Chinese strategic partnership has grown dramatically over the past decade. Both countries share an interest in undermining US global leadership and stoking American internal divisions. Both share an interest in reducing the US military presence near their borders, particularly in strategic territories and seas that they consider essential to their security and political legitimacy. Russia increasingly depends on Chinese demand for its exports and Chinese investment for developing its resources. Neither country trusts the other’s currency for trade but both have a shared interest in diversifying away from the US dollar (Chart 8). Chart 9China Offers Helping Hand On Iran? In cooperating with the US on Iran, Russia and China will expect the US to respect their demands on strategic areas much closer to their core interests. If the Biden administration continues to upgrade its trade and defense relations with Ukraine and Taiwan then Moscow and Beijing will push back aggressively and could at that point prevent or undermine any deal with Iran. China is at least officially enforce sanctions on Iran (Chart 9). Its strategic partnership with Iran is constantly in a state of negotiation – until the US clarifies its sanctions regime. Clearly China hopes to extract concessions from the Americans for cooperation on nuclear threats. This is also the case with North Korea, where a missile crisis would be useful for China’s purposes in creating the need for Chinese arbitration. China sees a chance to persuade Biden to remove restrictions imposed by President Trump. If the Biden administration’s hawkishness on China is confirmed in the coming months, then China’s willingness to cooperate will presumably change. Bottom Line: Israel is underscoring its red lines against Iranian nuclear weaponization and this will cause an increase in conflict this spring and summer. But it is not yet preventing the US and Iran from renegotiating the 2015 nuclear deal. We still expect Biden to agree to a deal by August. Taiwan And The South China Sea For global financial markets the most important test facing Biden lies in the US-China relationship and tensions over the Taiwan Strait. We will not rehash our recent research and arguments on this issue. Suffice it to say that we see a 60% chance of some kind of crisis over the next 12-24 months, including a 5% chance of full-scale war. The odds of total war can rise rapidly in the event of domestic Chinese instability, a game-changing US arms sale, or a Taiwanese declaration of independence. The greatest deterrent to a full Chinese attack on Taiwan – the reason for our current 5% odds – is that it would result in a devastating blowback against the Chinese economy. China’s trade with the developed world, in addition to Taiwan, makes up 63% of exports, or 11% of GDP (Chart 10). Beijing is ultimately willing to pay this price – or any price – to “unify” the country. But it will not do so frivolously. Each passing year gives China greater global economic leverage and greater military capability over Taiwan. Chart 10China’s Constraints Over Taiwan China is increasing its purchases of US treasuries, which waned during the trade war (Chart 11). China often increases purchases when interest rates rise and markets have seen a rapid increase in treasury yields since the vaccine discovery in November. There is no indication from this point of view that China is preparing for outright war with the United States, although this is admittedly a limited measure that could be misleading.   What about a crisis other than war? What do we mean when we say “some kind of crisis” over Taiwan? A major gray zone would be economic sanctions or an economic embargo. While China cut back on tourism after Taiwan’s nominally pro-independence party won the election in 2016, and all tourism ground to a halt with COVID-19, there is no evidence of a broader embargo so far (Chart 12). This could change overnight. While US law forbids an embargo on Taiwan, this is precisely an area where Beijing might wish to test the US’s commitment. Chart 11China Buys More US Treasuries The current high pressure on Taiwan stems in large part from the confluence of new US export controls and the global semiconductor shortage. China cannot yet meet its domestic demand for semiconductors and it cannot develop advanced computer chips fast enough without the US and its allies (Chart 13). Chart 12No Embargo On Taiwan (Yet) If the Biden administration pursues a full technological blockade then China may be forced to take tougher action on Taiwan. But if Biden pursues a more defensive strategy then a new equilibrium will develop that spares China the risks of war. Chart 13China's Demand For Semiconductors The US and China are simultaneously escalating their naval confrontation in the South China Sea, particularly around the Philippines. US and Chinese aircraft carrier groups and other ships have been circling each other as Beijing attempts to intimidate the Philippines and shake its trust in the defense treaty with the US. China claims the South China Sea as its own – and its efforts to deny the US access will be met with US assertions of freedom of navigation, which could lead to sunken ships. The strategic importance of the South China Sea is similar to that of the Taiwan Strait: Chinese control of these bodies of water would threaten Taiwan’s, Japan’s, and South Korea’s supply security while weakening America’s strategic position in the region. We have long highlighted the elevated risks of proxy war for Vietnam and the Philippines but these are hardly issues of global concern compared with Northeast Asia’s security. While Taiwan is far more relevant to global investors, due to the semiconductor issue, there are ample opportunities for a crisis to erupt in the South China Sea. A crisis in this sea cannot be dismissed as marginal because it could involve direct US-China conflict or, worst case, it could be a prelude to action on Taiwan, as China would seek to control the approaches to the island. The final risk in this region is that North Korea has restarted ballistic missile tests. As stated above, a crisis would be well-timed from China’s point of view. For investors, however, North Korea is largely a distraction from the critical Taiwan Strait. It could feed into any risk-off sentiment. Bottom Line: US-China relations are still unsettled and a clash could emerge over the South China Sea and Korean peninsula just as it could emerge over the Taiwan Strait. The Taiwan Strait remains the most significant geography. A direct US-China clash in the South China Sea could cause a global selloff but the markets would recover quickly, unless it is linked to a conflict over Taiwan. Investment Takeaways Geopolitical risk is reviving after a reprieve during the COVID-19 pandemic. That does not mean that frictions will lead straight into war. Diplomacy is possible. If the US, China, Russia, and Iran choose “jaw-jaw” over “war-war” then the global equity rally will see another leg up. From a tactical point of view, however, our arguments above should demonstrate that at least one of Biden’s early foreign policy tests is likely to escalate into a geopolitical incident that prompts negative impacts either in regional or global equity markets. Markets are not prepared for these risks to materialize. Standard measures of global policy uncertainty have fallen sharply for most countries. It is notable that two of the few countries in the world seeing rising policy uncertainty are China and Russia. The latter is likely due to domestic instability – which is a major motivator for an aggressive foreign policy (Chart 14). Chart 14AGlobal Policy Uncertainty Will Revive Chart 14BGlobal Policy Uncertainty Will Revive Global fiscal stimulus remains exceedingly strong – it is likely to peak this year. Chart 15 shows the latest update in fiscal stimulus for select countries, comparing the COVID-19 crisis to the 2008 financial crisis. There are some notable changes to previous versions of this chart, mostly due to revisions in GDP after last year’s shock, revisions in tax revenues due to the rapid economic snapback, and revisions to the timing and size of stimulus packages. The Biden administration’s $2.3 trillion infrastructure plan is obviously not included. The second panel of Chart 15 shows the changes in the IMF’s estimates from October 2020 to April 2021. Essentially the fiscal stimulus in 2020 was overestimated, as many measures did not kick in and the economic snapback was better than expected, whereas the 2021 stimulus is larger than expected. Russia and China are notable for tightening policy sooner than others – leading to a reduction in IMF estimates of fiscal stimulus for both years. Chart 15Revising Our Global Fiscal Stimulus Chart Commodities have been a major beneficiary of the global recovery (Chart 16). Chinese growth is likely to decelerate this year which will spark a pullback, even aside from geopolitical crises. However, from a cyclical perspective commodities, especially industrial metals, should benefit from limited supply and surging demand. Geopolitical crises and even wars would first be negative but then positive for metals. Chart 16Commodities To Benefit From Geopolitical Conflict Notably the US is embracing industrial policy alongside China and the EU. In particular the US is joining the green energy race with Biden’s $2.3 trillion American Jobs Plan containing about $370 billion in green initiatives and likely to pass Congress later this year. Symbolically Biden will emphasize the US’s attempt to catch up with Chinese and European green initiatives via his hosting of a global summit on April 22-23 for Earth Day. A brief word on the British pound. We took a tactical pause on our cyclically bullish view of the pound in February in anticipation of the Scottish parliamentary election on May 6. A strong showing by the Scottish National Party could lead to a second independence referendum. This party is flagging in the polls but independence sentiment has ticked back up, reinforcing our point that a nationalist surprise could take place at the ballot box (Chart 17). Once we have clarity on the prospect of a second referendum we will have a clearer view on the pound over the medium term. Chart 17Pound Sees Short-Term Risk From Scots Election Chart 18Long CHF-GBP For A Tactical Trade In the near term, we continue to pursue tactical safe-haven trades and hedges. Our tactical long Swiss franc trade was stopped out at 5% on March 25. But our Foreign Exchange Strategist Chester Ntonifor has since highlighted that the franc is excessively cheap (Chart 18). This time we recommend a tactical long CHF-GBP, which has an attractive profile in the context of geopolitical risk, taken together with the British political risk highlighted above.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 “Jaw-Jaw Is Best, Macmillan Finds,” New York Times, January 30, 1958, nytimes.com. 2 Taiwan – Province of China.

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Chart 2DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   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 Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Chart 10Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights On a timeframe of a few years, a net deflationary shock is a near-certainty even if we do not know its precise nature or its precise timing. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will ultimately reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this presents a mouth-watering 100 percent return on the long-duration T-bond. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should steer towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Fractal trade shortlist: Taiwan versus China, Netherlands versus China, and Sweden versus Finland. Feature Chart I-1For Long-Term Investors, A Shock Is A Near-Certainty Predicting shocks is easy. The precise nature and timing of shocks is not predictable, but the statistical distribution of shocks is highly predictable. This means that the longer our investment timeframe, the more certain we are of encountering at least one shock – even if we cannot predict its precise nature or timing. Many economists and strategists blame their forecasting errors on shocks, such as the pandemic, which they point out are ‘unforecastable.’ Absent the shocks, they argue, their predictions of the economy and the markets would have turned out right. This is a valid excuse for short-term forecasting errors, but it is not a valid excuse for long-term forecasting errors. On a long-term horizon, encountering a major shock, or several major shocks, is a near-certainty. Hence, economists and strategists who are not incorporating the well-defined statistical distribution of shocks into their long-term investment forecasts and strategies are making a mistake. Individual Shocks Are Not Predictable In the 21 years of this century so far, there have been five shocks whose economic/financial consequences have been felt worldwide: the dot com bust (2000); the global financial crisis (2007/8); the euro debt crisis (2011/12); the emerging markets recession (2014/15); and the global pandemic (2020). To these we can add two wide-reaching political shocks: the Brexit vote (2016); and Donald Trump’s shock victory in the US presidential election (2016). In total, this constitutes seven shocks, four economic/financial, two political, and one natural (Chart I-2). Chart I-2The Seven Global Shocks Of The Century (So Far) Some people argue that economic/financial shocks are predictable, because they arise from vulnerabilities in the economy or financial markets, which should be easy to spot. Unfortunately, though such vulnerabilities are obvious in hindsight, the greatest economic minds cannot see them in real time. The greatest economic minds cannot see economic vulnerabilities. Infamously, on the eve of the global financial crisis, Ben Bernanke was insisting that “there’s not much indication that subprime mortgage issues have spread into the broader mortgage market.” Equally infamously, on the eve of the euro debt crisis, Mario Draghi was asking “what makes you think that the ECB must become lender of last resort to governments to keep the eurozone together?” (Chart I-3 and Chart I-4) Chart I-3Bernanke Couldn't See The GFC Chart I-4Draghi Couldn't See The Euro Debt Crisis Which begs the question, what is the current vulnerability that today’s great economic minds cannot see? As we have documented many times, most recently in The Rational Bubble Is Turning Irrational, the current vulnerability is the exponential relationship between rising bond yields and the risk premiums on equities and other risk-assets (Chart I-5 and Chart I-6). Meaning that $500 trillion of risk-assets are vulnerable to any substantial further rise in bond yields. Chart I-5A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 Percent... Chart I-6...Than When The Bond Yield Started ##br##At 3 Percent The second type of shock – political shocks – should be predictable as they mostly arise from well-defined events such as elections and referenda, which an army of political experts analyses ad nauseam. Yet the greatest political minds could not see Brexit or President Trump coming. Indeed, even ‘Team Brexit’ didn’t see Brexit coming, because it had no plan on how to implement Brexit once the vote was won. The third type of shocks – natural shocks – are clearly unpredictable as individual events. Nobody knows when the next major pandemic, earthquake, volcano eruption, tsunami, solar flare, or asteroid strike is going happen. Yet, to repeat, while the precise nature and timing of shocks is not predictable, the statistical distribution of shocks is highly predictable. The Statistical Distribution Of Shocks Is Highly Predictable The good news is that shocks follow well-defined statistical ‘power laws’ which allow us to accurately forecast how many shocks to expect in any long timeframe. The 7 shocks experienced through the past 21 years equates to a shock every three years on average, or 3.33 shocks in any 10-year period. The expected wait to the next shock is three years. The next few paragraphs delve into some necessary mathematics, but don’t worry, you don’t need to understand the maths to appreciate the key takeaways. If the past 21 years is representative, we propose that the number of shocks in any 10-year period follows a so-called Poisson distribution with parameter 3.33. From this distribution, it follows that the probability of going through a 5-year period without a shock is just 19 percent, and the probability of going through a 10-year period without a shock is a negligible 4 percent (Chart of the Week). The result is that if you are a long-term investor, then encountering a shock is a near-certainty and should be built into your investment strategy. How can we test our assumption that the number of shocks follows a Poisson distribution? The maths tells us that if the number of shocks follows a Poisson distribution with parameter 3.33, then the ‘waiting time’ between shocks follows a so-called Exponential distribution also with parameter 3.33. On this basis, 63 percent of the waits between shocks should be up to three years, 23 percent should be four to six years, and 14 percent should be over six years. Now we can compare this expected distribution with the actual distribution of waits between the 7 shocks encountered so far in this century. We find that the theory lines up closely with the practice, validating our assumption of a Poisson distribution (Chart I-7 and Chart I-8). Chart I-7The Theoretical Waiting Time Between Shocks… Chart II-8…Is Close To The Actual Waiting Time Between Shocks To repeat the key takeaways, on a long-term timeframe, encountering at least one shock is a near-certainty, and the expected wait to the next shock is three years. A Shock Is A Near-Certainty, And It Will End Up Deflationary Nevertheless, there remains a pressing question: Will the next shock(s) be deflationary or reflationary? It turns out that all shocks end up with both deflationary and reflationary components: either a deflationary impulse followed by a reflationary backlash or, as we highlighted in The Road To Inflation Ends At Deflation, a reflationary impulse followed by a deflationary backlash. But the crucial point is that the deflationary component will swamp the reflationary component. In the seven shocks of this century so far, six have been deflationary impulses with a weaker reflationary backlash; and one – the reflation trade of 2017-18 – was a reflationary impulse with a stronger deflationary backlash. It is our high conviction view that in the next shock(s), the deflationary component will continue to hold the upper hand (Chart I-9). Chart I-9Each Shock Has A Deflationary And Reflationary Component... But The Deflationary Component Tends To Dominate The simple reason is that as financial asset prices, real estate prices, and debt servicing costs get addicted to ever lower bond yields, the economy and financial markets cannot tolerate bond yields reaching previous tightening highs and, just like all addicts, need a new extreme loosening to feel any stimulus. This means that when the next shock comes – as it surely will – it will require lower lows and lower highs in the bond yield cycle. Let’s sum up. On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise nature – economic/financial, political, or natural – or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will eventually reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this constitutes a mouth-watering 100 percent return on the long-duration T-bond. The 10-year T-bond yield will eventually reach zero. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should tilt towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Candidates For Countertrend Reversals This week we have noticed an unusual decoupling among the tech-heavy markets of Taiwan, Netherlands, and China (Chart I-10). Chart I-10An Unusual Decoupling Between Tech-Heavy Netherlands And China Among these three markets, the strong short-term outperformance of both Taiwan and Netherlands are due to supply bottlenecks in the semiconductor sector that have boosted Taiwan Semiconductor Manufacturing and ASML, but we expect these bottlenecks ultimately to resolve.  On this basis and combined with extremely fragile 130-day fractal structures, Taiwan versus China and Netherlands versus China are vulnerable to reversals (Chart I-11 and Chart I-12). Chart I-11Underweight Taiwan Versus China Chart I-12Underweight Netherlands Versus China Our first recommended trade is to underweight Netherlands versus China, setting a profit target and symmetrical stop-loss at 5 percent. Another outperformance that looks fragile on its 130-day fractal structure is Sweden versus Finland, driven by industrials and financials versus energy and materials (Chart I-13). Chart I-13Underweight Sweden Versus Finland Our second recommended trade is to underweight Sweden versus Finland, setting a profit target and symmetrical stop-loss at 4.7 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

We have been inundated with client requests on how to best position for President Biden’s sweeping infrastructure spending package. We therefore constructed the BCA Biden Fiscal Advantage Basket, which comprises eight ETFs and one stocks, all equal weighted (top panel). Instead of buying specific stocks we opted to go the ETF way in order to diversify away company specific risk. Our goal was to filter for ETFs that hold mostly US companies and that offered the highest possible liquidity. From a portfolio construction perspective, we tried to match the different spending segments of Biden’s preliminary bill (that our sister BCA US Political Strategy expects to pass Congress with high conviction) with an ETF. The ticker symbols of the eight ETFs and one stock we included in this Equity Basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. Granted there is some replication of stocks included in these ETFs, and in certain ETFs there is a sizable international stock exposure including EM and Chinese stocks. One final caveat is that these ETFs have a high concentration of technology stocks. Our sense is that this Basket should outperform the SPX on a cyclical and structural basis (middle panel). However, given the high tech exposure, our preferred way to express this trade is via a long/short pair trade versus the QQQ (bottom panel). Bottom Line: Initiate a long BCA Biden Fiscal Advantage Basket/short QQQ pair trade. On April 26, 2021 we will publish a joined SR with our sister US Political Strategy service on President Biden’s infrastructure spending bill proposal and elaborate further on this Equity Basket. The ticker symbols for the stocks in the BCA Biden Fiscal Advantage Basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. The table in the appendix on the next page shows a number of other related ETFs that did not make our cut, but that you may find interesting to research further.  

Highlights Structural headwinds are still too strong to hold a long-term bullish view on Eurozone equities relative to the US. However, the coming two years should be kind to euro area stocks. The relative performance of European stocks compared to that of the US is predominantly a function of yields. BCA foresees higher yields over a 24-month period. Moreover, European equities are exceptionally cheap, which accentuates their appeal as a yield play. Tactical considerations indicate that a modest overweight in European stocks, not an aggressive one, is most appropriate for cyclical investors. European investment grade bonds are appealing in a European fixed-income portfolio. Feature Chart 1Europe's Underperformance Explained Over the past decade, Eurozone equities have massively underperformed US ones. The poor outcome generated by European bourses mimicked the fall in European profits against the US (Chart 1). Considering that the relative performance of euro area stocks stands at an all-time low, should investors begin to bet on Europe? The outlook for yields favors European stocks on a cyclical basis. However, the structural picture suggests that both Europe and the US must experience fundamental changes before European stocks can surpass their US counterparts on a long-term basis.  Structural Challenges Remain The case for overweighting European equities on a structural investment horizon (5 to 10 years) remains weak. Only some major changes in the European and US economies can alter the long-term headwinds facing Eurozone stocks. Table 1US Possesses The Favored Sectors Sectoral biases partly explain Europe’s inability to match the US’s profit potential. The US market over-represents high-margin and high return-on-equity businesses, such as technology and healthcare, while most Eurozone bourses have significant weightings in the structurally challenged financial, materials, and energy sectors (Table 1). This difference in sector representation also explains the larger buybacks witnessed in US markets compared to euro area ones, which further boosted the US’s relative EPS. Chart 2Japan Never Recovered The performance of Japanese equities over the past three decades provides another cautionary tale for European stocks. Despite a substantial underperformance in the 1990s, Japanese equities never meaningfully recovered in the 2000s and ended up falling further behind the US over the past 12 years (Chart 2). A powerful liquidity trap and a 23% decline in the Japanese population compared to that of the US seriously hampered the ability of Japanese firms to generate stronger relative cash flows. This challenging profit picture meant that no matter how low JGB rates fell in comparison to the US, Japanese multiples never benefited from a significant re-rerating.  The Eurozone suffers from similar ills to that of Japan, which warns that the latter constitutes a valid template for European assets. Europe’s population is expected to decline by 16% relative to that of the US over the coming three decades, which will hurt sales and capex in Europe. Moreover, despite low interest rates, private credit demand is weak, which limits the region’s economic vigor. Most concerning, Europe’s capital stock as a share of GDP is substantial, especially in the periphery (Chart 3). Such an observation indicates that there is a high probability that previously misallocated capital is burdening the euro area. This misallocation will continue to hurt economic activity, because it encumbers demand via weak capex and also harms productivity. A DuPont decomposition of RoE reveals how Europe’s economic malaise affects corporate profitability (Chart 4). The Eurozone’s excessively large capital stocks means that its asset turnover is inferior to that of the US, which corroborates the notion that capital is misallocated. Moreover, the euro area’s low profit margins reflect more than its sectoral composition. Greater economic rigidities as well as lower market power and concentration in Europe hurt profitability (even if it limits inequalities compared to the US). Finally, the corporate sector is deleveraging, which is a consequence of a liquidity trap and poor trend growth, causing the ratio of RoE to RoA to decline relative to the US. Chart 3Too Much Capital Chart 4DuPont De No Good To reverse the structural outperformance of US equities relative to the Eurozone, Europe’s secular profitability underperformance must end. We will look for the following factors to stop this decline, which we will explore in further detail over time: European reforms. Europe will remain disadvantaged until its excess capital stock is written off. This process is complex and it will require greater fiscal integration as well as greater reforms to promote competition and to decrease labor market as well as service sector rigidities. More Innovation. Despite a strong patent record in economies such as Germany, Europe lags behind the US in the creation of leading innovative companies. Europe’s industrial and consumer discretionary sectors could prove beneficiaries of the green revolution taking place around the world, but it is still too early to tell. Chart 5Market Power Helps The US An ossification of the US economy. Europe could also begin to outperform, because the US might lose its edge. Economic populism is rife in the US, fueled by growing discontent with economic inequalities. As a result, government involvement in the economy as well as regulatory efforts could increase significantly. While a push to redistribute income toward the middle class would alleviate inequalities, it would hurt profitability and cause US RoE to decline toward European levels (Chart 5). Bottom Line: The secular underperformance of Eurozone equities reflects their inability to generate as much profits as US ones. Beyond sector biases, Europe’s demographic hurdles and its deeper problem with secular stagnation remain its key handicaps. For now, there is no solid case to bet on a major change in these trends, which only European reforms or problems in the US can undo. But A Cyclical Opportunity Exists Despite the challenging structural environment for European equities, the cyclical outlook (24 months) is attractive. Even in Japan, multi-year episodes of outperformance punctuated a decades-long underperformance relative to the US or the MSCI all-country world index. In the case of the Eurozone, this upbeat view rests on BCA Research expectations of higher global yields. The performance of Europe’s equities relative to the US correlates closely with the level of US yields (Chart 6). The sectoral footprint of both bourses is an important driver of this correlation. The US overweighs growth and defensive stocks, which account for 49% and 23% of its capitalization, respectively. Meanwhile, the euro area over-represents value stocks and deep cyclicals, which account for 55% and 26% of its market, respectively. Historically, global value stocks beat growth equities when yields are rising (Chart 7).  Chart 6A Yield Story Chart 7What Value Likes The outperformance of value stocks when yields rise is multifaceted. Deep cyclicals, such as industrials, materials, financials and energy, constitute a larger share of value benchmark than growth ones. Consequently, when yields increase because the global business cycle experiences an upswing, the earnings of value stocks accelerate compared to those of growth stocks (Chart 7, bottom panel). The positive impact of yields on the value versus growth split is also more direct. Higher yields, especially if they accompany a steeper yield curve, boost the profitability of financials. Meanwhile, mounting yields increase the discount factor applied to the long-term deferred cash flows that contribute a large proportion of the intrinsic value of growth stocks. Higher yields also support the relative performance of Eurozone stocks via the evolution of the expected growth rates of their long-term earnings. As Chart 8 illustrates, upgrades to sell-side estimates of the long-term growth rate of European EPS relative to the US coincide with a steeper US yield curve slope and rising 5-year/5-year forward Treasury yields. These relationships exist because European economic activity and sectoral representation are more cyclical than that of the US.  Eurozone equities look like a particularly cheap bet on higher yields over the coming 18 to 24 months. Sentiment toward European assets remains depressed compared to the US. Even on an equal-weighted basis, the discount of the expected long-term growth rate of euro area EPS relative to the US is exceptionally wide (Chart 9, top panel). True, the sustainable growth rate (SGR) of earnings is a function of the return on equity and the dividend payout ratio. Nonetheless, despite the fact that the euro area low RoE forces the European SGR down, Eurozone stocks embed a long-term growth rate that is 47% too low vis-à-vis the US. Other metrics underscore the cheapness of European equities relative to the US. Our Mechanical Valuation Indicator, which is sector neutral, stands at a 1-sigma discount in favor of the Eurozone (Chart 9, bottom panel). Chart 8EPS Growth and The Yield Structure Chart 9Europe Is Cheap Ultimately, Europe’s relative expected growth and valuations are particularly depressed, because domestic activity lags behind that of the US by a significant margin. As the vaccination campaign advances and the economy reopens later in the quarter, the Eurozone’s service sector will catch up and the earnings growth discount will dissipate (Chart 10). Moreover, regardless of its recent dynamism, even the European industrial sector has room to catch up to the US. Our Swedish Economic Diffusion Index captures the general strength in Swedish economic activity, which foretells a further increase in both the euro area Manufacturing PMI and equities relative to the US (Chart 11). Chart 10Stronger Services Will Help Chart 11Listen To Sweden Bottom Line: BCA’s expectations that global yields will rise over the coming 24 months are consistent with Eurozone equities outperforming US ones over this period, even if the long-term outlook remains challenging for Europe. European equities are much more pro-cyclical than US ones, which is reified by their sector and value biases. Moreover, euro area equities currently embed a particularly large discount to their US counterpart, which increases their attractiveness as a play on rising bond yields. The Right Entry Point? Strategy and forecasts are two different things. BCA strongly believes that yields will rise over the coming two years; however, a large overweight in Eurozone equities is a risky bet at the current juncture. Instead, we recommend investors opt for a modest overweight. Short-term traders should stay clear of this market for now. The reason for this cautiousness is that yields are very vulnerable to a temporary near-term pullback because: Chart 12A Countertrend Bond Rally? Technicals point to a counter-trend bounce in bond prices. Our BCA Composite Technical Indicator is massively oversold, our Composite Sentiment Indicator is extremely depressed, and speculators are aggressively shorting T-Bonds (Chart 12). The recent bond market behavior is puzzling. Despite March’s blockbuster non-farm payroll data and Manufacturing, as well as Services ISM surveys, yields are softening. Not even the announcement of the Biden administration’s $2.3 trillion American Jobs Plan could increase yields in recent weeks. This price action confirms that bonds are oversold and that, until the recent price decline is digested, the threshold to push yields higher has risen meaningfully. Equities are at risk of a pullback. Euphoria is prevalent, which increases the odds of corrective action in equities. Our BCA Equity Capitulation Index stands at a 45-year high (Chart 13) and our US Equity Strategy team’s Risk Appetite Index is at its highest levels since 2007, both of which suggest that complacency is rife. Moreover, the put/call ratio has collapsed to 0.45, which shows the carefree attitude of traders. Yields will decline if stock prices correct. EM equities are underperforming US stocks. EM benchmarks are more sensitive to marginal changes in the global growth outlook. For now, the risk is that growth disappoints lofty expectations. Since 2014, periods of relative weakness in EM bourses precede declines in Treasury yields (Chart 14). Authorities are trying to limit credit growth in China. As we argued two weeks ago, Beijing is aiming to slow credit growth to prevent systemic vulnerabilities from developing. This process is fraught with risks and is likely to result in a deceleration in China’s economy. While Europe and most emerging markets remained mired in a health crisis, China will be a source of temporary downside for global economic activity. The recent announcement that the PBoC asked Chinese banks to limit new loans confirms this assessment. Chart 13Euphoria! Chart 14EM Stocks Are Telling Us Something Bottom Line: For now, investors with a cyclical horizon (two years) should only keep a modest overweight position in Eurozone equities because the near-term outlook for yields points to some temporary downside. Not allocating the full allowable capital budget to Europe will allow investors to upgrade their overweight after the near-term downside in yields has passed. Investors may also consider implementing some hedges. Our foreign exchange strategist recommends a short EUR/JPY position as a form of portfolio protection. Keeping some cash in yen to deploy later in Europe mimics this advice. Short-term traders should stay clear of Europe as long as bond markets have not digested their oversold condition. Market Focus: Investment Grade Corporates and the ECB The ECB’s minutes highlight that investment grade corporate bonds are attractive within European fixed-income portfolios. The recently released ECB minutes revealed that higher real rates do not overly concern the Governing Council, because they reflect an improving global economic outlook and not an eventual policy tightening. Moreover, the GC does not want to give the impression it will engage in yield control, yet the pace of purchases under the Pandemic Emergency Purchase Programme (PEPP) will remain accelerated and flexible until June, at a minimum. The ECB will not derail the supportive environment for economic activity anytime soon. Meanwhile, as we have argued in past reports, fiscal policy in Europe will also stay relaxed for the time being. Thus, the Eurozone’s policy environment remains supportive for credit spreads, especially since the default cycle has been muted. However, do corporate bonds already fully price in this positive backdrop? According to the 12-month breakeven spread, European credit spreads can compress further. The breakeven spread is the amount of spread widening required for corporate bond returns to break even with a duration-matched position in government bond securities over a 12-month horizon. It is approximated by dividing the OAS of a bond (or an index) by its duration. The breakeven spread is then compared to its own history, by observing the percentage of time that it has been lower in the past.1  Chart 15Some Value Left European credit spreads have tightened 160 bps since March last year and are already below their pre-Covid level (Chart 15). However, the 12-month breakeven spread has been tighter 18% of the time since 1999. In other words, higher quality corporate bonds in Europe have room to see further spread compression, since policy will remain relaxed for a long time. This is especially true in the Aa-rated credit tier, where the breakeven spread has been more expensive 35% of the time (not shown). Meanwhile, US breakeven spreads for IG corporate bonds are in their 2nd percentile and policy will tighten sooner than in Europe. Therefore, bond investors with a European-only mandate are not forced to step down the quality ladder as aggressively as those in the US do. Table 2Norway, France And Italy Stand Out Table 2 provides the same analysis at the country level. Taking into consideration the average credit rating of each countries’ investment grade bonds, we find that Norwegian, French, and Italian spreads have the most value left. Interestingly, the ECB’s purchases of Italian and French paper is currently deviating widely from its capital keys, which should place downward pressure on credit spreads in these jurisdictions. Bottom Line: There is still value left in European investment grade corporate bonds, unlike in the US, where valuations are extremely expensive and a decrease in quality is warranted. For now, such a move is uncalled for in Europe, especially since the value in its high-yield index is concentrated in its riskiest credit tiers. At the country level, investors should favor Norwegian, French, and Italian investment grade corporate bonds.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Jeremie Peloso, Senior Analyst JeremieP@bcaresearch.com   Footnotes 1We find this valuation tool superior to others for two main reasons: (i) using the breakeven spread rather than the average index OAS allows us to control for the changing average duration of the benchmark bond indices; and (ii) the percentile rank is often a better representation of credit spreads than the spread itself.   Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades