Developed Countries

Highlights Euro Area debt loads have increased significantly during the pandemic. Debt loads are not uniform. While Germany and, to a lesser extent, Spain look best, France has a less attractive total debt profile than Italy. Government debt-service ratios are not a problem for Europe. Private sector debt service ratios do not represent an imminent risk, but the French corporate sector is an important source of long-term vulnerability for the region. As a result of this indebtedness, Euro Area bond yields will not rise much and will be capped below 1.5% over this business cycle. For now, Eurozone corporate bonds remain attractive within a European fixed-income portfolio. High-yield bonds are appealing, but investors should avoid the energy sector. Feature Like the US, the Eurozone economy has witnessed a large increase in debt following the COVID-19 crisis. This debt load will have a long legacy that will impact the ability of the European Central Bank to increase interest rates over the coming years. The French corporate sector will be a particularly vulnerable pressure point. Nonetheless, in the short-term, this uptick in indebtedness will not have a major impact on European debt markets. Disparate Debt Loads… Chart 1The Eurozone's Heavy Debt Load After a period of decline in the wake of both the GFC and the European debt crisis, total nonfinancial debt rose by 29% of GDP since the COVID-19 pandemic began (Chart 1). While some of this increase reflects a declining GDP, Euro Area Households and Corporations together added EUR609 billion of debt, while governments accumulated over EUR1 trillion more to their borrowings. The aggregate European picture does not impart the more complex reality. While all countries experienced a marked rise in indebtedness, some major economies are in a much more precarious position than others. The Good Among the largest Eurozone economies, Germany sports the most favorable debt profiles and represents the smallest threat to the Eurozone. Compared with the other major Euro Area countries, Spain shows healthier trends, even if its overall debt load remains important. At 202%, Germany’s nonfinancial-debt-to-GDP ratio is still below its all-time high of 211% (Chart 2, top panel). During the crisis, household debt rose by EUR296 billion or 4% of GDP, but it still stands well below the 72% registered at the turn of the millennium. In absolute terms, nonfinancial corporate debt has increased to a record, but it remains 5% below its 2003 high (Chart 2, third panel). Despite a 9% rebound to 70% of GDP, government debt still lies nearly 12% below its 2010 summit (Chart 2, bottom panel). In Spain, total nonfinancial debt rose by 45% of GDP since the pandemic started, but remains 12% below its 2013 all-time high of 301%. However, the private sector’s borrowing is well behaved, and it has only risen to 170% of GDP, well below the 227% level recorded in 2010 (Chart 3, top panel). Both the household and corporate sectors have gone a long way toward improving their debt situation, with borrowing 23% and 33%, respectively, below their crisis peaks (Chart 3, second and third panel). Spain’s problem is government debt. The pandemic forced the public sector to borrow EUR316 billion, which pushed its debt load to 120% of GDP (Chart 3, bottom panel). Chart 2Germany Is The Best Student Chart 3Spain's Previous Efforts Have Paid Off The Bad Chart 4Italy Remains Problematic Italian debt remains a troublesome spot for the Eurozone, which sheds some light on the higher interest rate commanded by BTPs. Burdened by tepid GDP growth, Italy’s total nonfinancial debt did not decline much in the years between the European debt crisis and the onset of the pandemic. As a result, overall nonfinancial debt jumped to an all-time high of 276% of GDP in response to COVID-19 (Chart 4, top panel). Private sector nonfinancial credit is high by Italian standards, but at 120% of GDP, it is low compared with other major European or G-10 nations. Italian household debt has hit a record high of 45% of GDP, which also compares well to other countries, while corporate debt rose to 76% of GDP, which is also well below historical highs and other nations (Chart 4, second and third panels). Italy’s perennial problem remains the public sector’s debt, which stands at 156% of GDP, the highest reading among major Eurozone nations. The Ugly The major Eurozone country with the worst debt situation is France, and we expect this country to become an increasingly large hurdle on the ability of the ECB to lift rates in the future. Next week, we will devote a Special Report to the French situation. Chart 5France's Debt Binge France’s nonfinancial debt towers above 350% of GDP, and the private sector nonfinancial debt has also hit an all-time high of 240% of GDP (Chart 5, top panel). No sector is spared. French households have accumulated EUR239 billion of liabilities during the pandemic, which pushed their leverage ratio to an all-time high of nearly 70% of GDP (Chart 5, second panel). Meanwhile, after rising by 21%, nonfinancial corporate credit stands above 170% of GDP (Chart 5, third panel). Finally, at 116% of GDP, public debt may not be as high as in Italy, but it is comparable to that of Spain (Chart 5, bottom panel). Bottom Line: The Eurozone indebtedness has hit a record high, but considering this factor in isolation oversimplifies a complicated picture. Among the major economies, Germany has the cleanest balance sheet, especially in terms of its private sector. Spain continues to sport high leverage, but the private sector remains in much better shape than last decade. Italy has made little progress, but it still looks good compared with France, where both the public and private sector borrowings stand at record highs. … And Debt Servicing Costs With the exception of the French corporate sector, debt-servicing costs do not represent a great risk for Europe. Chart 6Interest Payments Are Not The Government's Problem When it comes to governments, the picture is particularly benign. As Chart 6 illustrates, debt-servicing costs as a percentage of GDP or tax revenues are extremely low in both France and Germany. While these two variables are higher in Italy and Spain, they remain distant from the levels recorded during the European debt crisis. Beyond their low levels, a very accommodative policy environment limits the risk created by Europe’s public debt servicing costs. The ECB has purchased EUR1.3 trillion of government bonds since April 2020, which added to its already large ownership. Moreover, BCA’s Global Fixed Income Strategy service, as well as this publication, anticipates that the ECB will roll the stock of government paper purchased under the PEPP into the PSPP. Beyond the ECB’s actions, the NGEU funds also create the embryo of fiscal risk sharing in the EU, which limits how far yields (and thus debt servicing costs) will rise in the Italy or Spain. For the private sector, the picture is more nuanced. In Germany, household debt-servicing costs are low, both historically and compared with other nations. Meanwhile, BIS data highlights that the nonfinancial corporate debt services consume a larger share of operating cash flows than at any point over the past 20 years, but they remain low by international standards (Chart 7, top panel). Meanwhile, in Spain and Italy, both the household and nonfinancial corporate sectors sport historically low debt servicing costs (Chart 7, second and third panels), which also compare well to other OECD nations. Once again, France stands out. Its household debt servicing costs are historically elevated, even if they are not particularly demanding at a global level. However, the corporate sector spends a substantial share of its cash flow on debt, both compared with its own history and internationally (Chart 7, bottom panel). Chart 7Debt Servicing Costs Across Europe Bottom Line: Generally, the debt-service picture in Europe does not represent a major threat for now. While risks are particularly well contained on the government front, the French corporate sector creates danger for the private sector. Investment Implications The elevated debt load in the Euro Area, especially in the corporate sector, constitutes a crucial limiting factor for interest rates in Europe over the coming business cycle. Compared with global economies, the Eurozone corporate sector sports elevated debt ratios. As Chart 8 illustrates, the Eurozone’s net debt-to-equity ratio is higher than that of the US across most sectors, and even surpasses that of Canada, another country with a heavily indebted corporate sector, for telecommunication firms and financials. The picture is even worse when looking at the net debt-to-EBITDA ratio. Except for energy and utilities, the Eurozone carries poorer numbers than both the US and Canada (Chart 9). Chart 8Debt-To-Equity Ratio Comparison Chart 9Net Debt-To-EBITDA Comparison The picture for debt service payments is even more damning. Despite the very low European corporate bond rates, Eurozone corporations generally have poorer interest rate coverage ratios than both the US and Canada (Chart 10). This indicates that, unless the subpar European profitability is resolved, significantly higher interest rates will cause significant damage to the European corporate sector. Chart 10Interest Coverage Lags In Europe Chart 11The French Corporate Sector And Dutch Households Will Limit The ECB On this front, the French corporate sector once again stands out as the most likely place for an accident. As the top panel of Chart 11 shows, French firms are positioned especially poorly, with both their debt-to-GDP and debt-servicing costs among the highest in advanced economies. Meanwhile, in the household sectors, only the Netherlands represents a potential risk (Chart 11, bottom panel). The level of corporate debt in the Eurozone and in France in particular suggests that the current level of yields in Canada may represent a cap on European long-term rates. Thus, it will be difficult for German yields to move beyond the 1% to 1.5% zone this cycle. For now, despite the elevated debt loads of the European corporate sector, we continue to overweight corporate bonds within European fixed-income portfolios. The ECB will maintain very accommodative monetary conditions for the next 24 months, at least. Moreover, the European recovery, especially in the service sector, will improve the operating cash flows of the corporate sector, and thus, increase the tolerance of the private sector for higher yields in the near terms. Finally, the strength in the Euro anticipated by BCA’s Foreign Exchange strategists will limit the upside to Eurozone inflation, and thus, to yields in the region. Nonetheless, investors should avoid certain sectors (see next section). Market Focus: How To Play Euro Area High Yield Bonds? Chart 12Valuations Are Getting Expensive We have argued that investors should continue to favor investment grade corporate bonds within European fixed-income portfolios over high-yield corporate bonds. Eurozone investment grade credit still offered enough value to delay a move down in quality (Chart 12). However, this value cushion is thinning and spreads are only 10 bps from their 2018 lows. BCA Research’s Global Fixed-Income strategists have recently increased their allocation to Euro Area high-yield to overweight, with a focus on the Ba-rated credit tier, while maintaining a neutral weighting in IG credit.  However, European high-yield is also becoming expensive. The yield on the overall index is a meagre 44 bps away from its lows of 2018. Moreover, the breakeven spreads of European junk bonds have only been more expensive 11% of the time since 2000 (Chart 12, bottom panel). Despite these observations, high-yield credit is not a uniform block. Caa-rated debt still offers decent value, with a breakeven spread historical percentile standing at 27%. The stretched level of valuation suggests that investors should become more selective in the high-yield space, in order to avoid the industries with the worst risk profiles. To assess the sectors most at risk of experiencing significant spread widening or default occurrences in the coming quarters, we evaluate how the 10 main high-yield industry groups, as defined by Bloomberg Barclays, perform on the following credit metrics: Risk profile The share of firms rated Caa Growth in value of debt outstanding over the past 10 years Change in net debt-to-EBITDA ratio over the past 10 years Risk Profile Chart 13Risk Profile Of HY Sectors We look at the duration-times-spread (DTS) ratio to determine the risk profile of each sector (Chart 13). The DTS is a simple measure that correlates closely with excess return volatility for corporate bonds. The ratio of an issue’s, or sector’s DTS, to that of the benchmark index is loosely equivalent to the beta of a stock or industry to the equity benchmark. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”); a DTS ratio below 1.0 indicates that the sector is defensive (or “low beta”). Cyclical sectors are expected to outperform (underperform) the benchmark when spreads are narrowing (widening), while the opposite is expected of defensive sectors. In Europe, only three sectors sport a high DTS. Within these cyclical sectors, energy clearly stands out as essentially being the one most at risk of underperforming during the next episode of spread widening. Meanwhile, materials, healthcare, and utilities display the lowest DTS ratios and should trade defensively relative to the high-yield benchmark index. Share of Caa-rated debt Chart 14High Share Of Caa-Rated Debt Implies Higher Risk Of Default The bulk of defaults happens in the Caa-rated space and below. Hence, evaluating sector risk starts by assessing the share of Caa-rated (and below) debt sported by each industry (Chart 14). Sectors bearing a larger share of low-rated debt should display higher spreads. Consumer non-cyclicals and healthcare have the highest instance of low-rated debt, 16% and 13% respectively, and yet their spreads do not adequately compensate investors for this threat. The energy sector also stands out: spreads are wide because, despite the low percentage of Caa-rated debt, this sector has amassed considerable debt and has seen a meaningful deterioration in net debt-to-EBITDA (see below). Meanwhile, utilities shine under this metric, as they have not issued debt rated Caa or lower. Debt Growth Chart 15Debt Growth Justify Spread Levels The speed and amount of debt accumulated during economic recoveries are other important determinants of future spread volatility, because the sectors that have rapidly levered-up are more likely to experience defaults. Chart 15 shows that, if we ignore the outlying utilities, then there is a robust positive linear relationship between this metric and spreads. Utilities, energy, and the tech sectors have added the most debt, while debt accumulation in the basic materials and health care sectors has lagged over the past 10 years. Crucially, tech and communications spreads trade below what their debt growth implies. Net Debt-To-EBITDA Chart 16Only Financials Have Improved Their Net Debt-To-EBITDA A rapid debt accumulation is not a concern, as long as earnings are rising more rapidly or at least at the same pace. From this case, we infer that companies are using the new debt issued efficiently, for CAPEX or to pursue projects exceeding their IRR. In this light, wide spreads are justified for the energy, consumer cyclical, and consumer non-cyclical sectors (Chart 16). Conversely, financials have seen improvement. Bottom Line: After surveying Euro area high-yield corporate sectors based on four credit metrics, it appears that the sectors most at risk are energy and consumer non-cyclical. By contrast, basic materials seem to be a good sector in which to hide.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance

Weekly Performance Update For the week ending Thu Jun 24, 2021 The Market Monitor displays the trailing 1-quarter performance of strategies based around the BCA Score. For each region, we construct an equal-weighted, monthly rebalanced portfolio consisting of the top 3 stocks per sector and compare it with the regional benchmark. For each portfolio, we show the weekly performance of individual holdings in the Top Contributors/Detractors table. In addition, the Top Prospects table shows the holdings that currently have the highest BCA Score within the portfolio. For more details, click the region headers below to be redirected to the full historical backtest for the strategy. BCA US Portfolio Total Weekly Return BCA US Portfolio S&P500 TRI 1.19% 1.08% Top Contributors   TX:US SCCO:US DE:US UHAL:US TGT:US Weekly Return 28 bps 19 bps 19 bps 17 bps 12 bps Top Detractors   MPLX:US HE:US PEG:US STX:US FLO:US Weekly Return -10 bps -10 bps -9 bps -8 bps -7 bps Top Prospects   BRK.A:US ANAT:US ESGR:US TX:US MPLX:US BCA Score 98.55% 98.15% 97.91% 97.86% 93.55% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI 2.34% 0.38% Top Contributors   TOY:CA AUP:CA CS:CA TOU:CA IFP:CA Weekly Return 43 bps 38 bps 36 bps 19 bps 16 bps Top Detractors   EMP.A:CA TCL.A:CA CCA:CA QBR.A:CA ELF:CA Weekly Return -23 bps -7 bps -7 bps -5 bps -3 bps Top Prospects   CS:CA IFP:CA RUS:CA CFP:CA LNF:CA BCA Score 99.28% 98.50% 98.21% 97.43% 97.22% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI 0.23% -0.53% Top Contributors   ROSN:GB CVSG:GB KNOS:GB BIFF:GB NFC:GB Weekly Return 20 bps 14 bps 14 bps 14 bps 14 bps Top Detractors   NLMK:GB DEC:GB BAKK:GB TEP:GB LXI:GB Weekly Return -19 bps -15 bps -15 bps -12 bps -11 bps Top Prospects   SVST:GB NLMK:GB GLTR:GB BPCR:GB RMG:GB BCA Score 99.67% 98.62% 98.47% 95.23% 95.08% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI -0.86% -0.52% Top Contributors   MMT:FR WUW:DE FSKRS:FI MS:IT UN01:DE Weekly Return 13 bps 13 bps 11 bps 10 bps 9 bps Top Detractors   CNV:FR GTT:FR ADL:DE PHA:FR US:IT Weekly Return -53 bps -19 bps -16 bps -10 bps -8 bps Top Prospects   STR:AT POST:AT CNV:FR SOLV:BE HLAG:DE BCA Score 99.42% 98.85% 98.74% 97.65% 96.86% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI -0.58% -0.84% Top Contributors   7860:JP 6676:JP 7958:JP 8117:JP 5930:JP Weekly Return 13 bps 12 bps 12 bps 9 bps 7 bps Top Detractors   9543:JP 8595:JP 7994:JP 3132:JP 8922:JP Weekly Return -17 bps -17 bps -13 bps -10 bps -8 bps Top Prospects   4966:JP 6345:JP 8133:JP 9543:JP 7994:JP BCA Score 99.33% 98.60% 98.49% 98.45% 98.11% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI 0.47% 1.23% Top Contributors   990:HK 316:HK 1798:HK 857:HK 1258:HK Weekly Return 121 bps 36 bps 23 bps 21 bps 14 bps Top Detractors   3600:HK 1919:HK 43:HK 743:HK 323:HK Weekly Return -73 bps -28 bps -20 bps -18 bps -12 bps Top Prospects   990:HK 2232:HK 811:HK 1606:HK 323:HK BCA Score 99.11% 98.28% 97.72% 97.55% 97.08% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI 1.52% -0.80% Top Contributors   AGI:AU GRR:AU RUL:AU CAJ:AU PDN:AU Weekly Return 85 bps 18 bps 16 bps 13 bps 12 bps Top Detractors   STX:AU AST:AU SDG:AU SGF:AU EVT:AU Weekly Return -27 bps -15 bps -15 bps -6 bps -6 bps Top Prospects   PIC:AU GRR:AU AGI:AU SGF:AU BFG:AU BCA Score 98.36% 98.09% 97.54% 96.84% 96.80%

Special Report

Dear client, In lieu of our weekly bulletin next Friday, I will be hosting a webcast on Tuesday, June 29 to discuss the latest trends in FX markets, given the hawkish shift by the Federal Reserve. I hope to answer your questions during this webcast. Kind regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights The hawkish shift by the Federal Reserve last week jolted the dollar higher, but our bias is that the rally will be quite short-lived. The primary reason is that US real rates will remain depressed, relative to the rest of the world, for the foreseeable future. The US balance of payments backdrop continues to deteriorate suggesting that the willingness by foreign concerns to fund the trade deficit will be a drag on the dollar. Global trade is staging a recovery. Historically, this has been synonymous with stronger global growth and a weaker dollar. Most countries are seeing foreign direct investment (FDI) inflows accelerate in the first few months of 2021, on the back of potential profitable investment projects. This is set to continue. The advantage appears to be particularly pronounced in commodity-producing countries that are witnessing a strong terms-of-trade tailwind. Feature Chart I-1The Dollar Rallied Hard On The Fed Shift Last week, the Federal Reserve surprised markets with a hawkish shift. First, the median dots suggested at least two rate hikes by the end of 2023, a shift from the March communiqué where no rate hikes were expected until 2024. Second, the Fed revised its inflation forecast for 2021, from 2.4% to 3.4%, while suggesting that this should still be transitory. Longer-term inflation expectations were left largely unchanged. Finally, the discussion around tapering was acknowledged, which was interpreted as a sign that the Fed was inching closer to withdrawing monetary stimulus. The reaction in the FX market was violent. From a low of 90.5 last week, the DXY index rallied 2% and currently sits at 91.8. The most hit currencies were procyclical, even where central bankers have been more hawkish than the Fed, such as Norway and New Zealand (Chart I-1). Our initial take was that the market moves were a knee-jerk reaction, likely to be sustained in the coming weeks and months but would prove fleeting. As we finally digest the implications of the Federal Reserve’s shift, it is difficult to make the case for a sustainable rally in the US dollar. The jump in the dollar coincided with an upward revision in market expectations for rate hikes in 2022 and 2023. Markets now expect the Fed to lift interest rates by 34 bps in 2022 and an additional 51 bps in 2023. Notably, this is higher than what the market expected at the start of the year (Chart I-2, top panel). On the surface, this explains the dollar rally. But market interest rate expectations between the US and the rest of the world were largely unchanged, as real rates moved higher almost everywhere within the G10 (Chart I-2, bottom panel). From this perspective, the dollar rally was largely an overreaction. Higher inflation in the US, especially compared to the rest of the world, has usually been a bearish development for the dollar. The simple reason is that the fair value of the currency incrementally declines on a purchasing power parity basis. Therefore, the Federal Reserve’s adjustment higher of US inflation should not have reinvigorated bulls, unless they believe the Fed will actively move ahead of the inflation curve (Chart I-3). We did not get such a reading from last week’s release. And given that the US is generating the fastest inflation in the G10 and has the sole central bank targeting an inflation overshoot, our bias is that real rates will remain depressed for the foreseeable future Chart I-2Long-Term Rates Did Not Shift In Favor Of The Dollar Chart I-3Higher Inflation In The US Is Negative For The Greenback The Fed suggested that discussions have begun around tapering, but again, this was little reason for a rally in the dollar. Market participants had already expected tapering to begin sometime next year (Table I-1A and I-1B). Meanwhile, the Fed reiterated that any tapering discussions will be communicated well in advance. It is also worth noting that the Fed is lagging other central banks in tapering asset purchases, notably the Bank of Canada. Table 1AMarket Participants Already Expect The Fed To Taper Next Year Table I-1BMarket Participants Already Expect The Fed To Taper Next Year The above analysis suggests that the Fed provided an excuse for an oversold dollar to bounce higher, rather than trigger a sea change in the currency outlook. So, from a tactical perspective, the rally could continue, pushing us towards 94 on the DXY. However, longer term, the underlying drivers of the dollar suggest a bearish view remains appropriate. This week’s report focuses on one such longer-term driver – the balance of payments. The US trade deficit continues to widen at an accelerating pace, while improving in many other countries. From this perspective, the willingness by foreign concerns to fund the trade deficit will continue to be a drag on the dollar. Global Trade And The Dollar In Q1 2021, global trade was higher than pre-crisis levels, rising 10% year-on-year. According to the United Nations Conference on Trade and Development (UNCTAD), the strong rebound continues to be driven by the strong exports from East Asian economies. These trends are expected to continue in the near-term, especially once trade in services can resume in earnest on the back of vaccination progress. Chart I-4US Balance Of Payments Are Negative For The Dollar Global FDI inflows should also begin to rebound going into next year, following a tumultuous decline in 2020. According to UNCTAD, global FDI inflows plunged by 35%, bringing total FDI inflows to below US$1 trillion. As reinvested earnings make up a huge share of total FDI, the earnings decline last year curtailed flows. Looking ahead, UNCTAD expects FDI flows to recover fully in 2022, under their optimistic scenario. Over the much longer term, the headwinds to trade and FDI flows remain, including rising protectionism, global onshoring of production and geopolitical tensions. De-globalization is here to stay, as policymakers promote more regulation and intervention in key industries. That said, over the next few years, balance of payments dynamics will remain important and could be the key driver for currencies, as investors become more discerning between countries and sectors with a high return on capital and those without. In this report, we look at the balance-of-payment dynamics in the G10. Specifically, the basic balance, which takes the sum of the current account and net long-term capital inflows (and therefore tends to measure the underlying competitiveness of a currency more accurately). On this basis, Sweden, the euro area, Australia and Norway sport the best surpluses, while the US is the worst (Chart I-4). United States Chart I-5US Balance Of Payments The US basic balance is deteriorating at an accelerating pace (Chart I-5). Just this week, the current account balance for Q1 came in at -$195.7 billion, the widest in over a decade. This is also occurring at a time when FDI inflows are deteriorating. If this trend continues, it could continue to undermine the US currency. The basic balance is approaching -4% of GDP. This has reversed most of the improvement in the basic balance since the Global Financial Crisis. This confirms our bias that the dollar likely put in a major top last year and has entered a multi-year decline. On portfolio flows, the most recent TIC data show that US Treasurys were aggressively bought in March and April by foreigners. Equity inflows also remain strong. However, should US real rates remain deeply negative, this will curtail foreign appetite for US government bonds, and require an adjustment lower in the dollar.           Euro Area Chart I-6Euro Area Balance Of Payments The euro area maintains a structural current account surplus, which has been improving in recent quarters (Chart I-6). Since the beginning of the year, the surplus has increased from €5.8 billion to €31.4 billion in April. Meanwhile, after about two decades of underinvestment in the euro area, FDI inflows are now at the strongest level, to the tune of about 2% of GDP. This is nudging the euro area’s basic balance to a record 4% of GDP. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. This is likely to persist, as strong FDI inflows, especially in the green energy sector, continue. Portfolio investment has turned strongly negative in recent quarters, but this is likely a crowding out of bond investors by strong purchases from the ECB. Meanwhile, the euro area generates a surplus of savings that need to be reinvested abroad.             Japan Chart I-7Japan Balance Of Payments Ever since the Fukushima crisis, the Japanese trade balance has been severely hampered by rising energy imports. The key pillar for the basic balance surplus is income receipts from Japan’s large investment positions abroad. This should continue to keep the basic balance in surplus, albeit at lower levels than a decade ago (Chart I-7). Going forward, the Japanese trade balance should keep improving as exports maintain their strong growth. On the service side of the equation, foreign visitors should also increase, especially as the Olympics move ahead. At their peak, foreign visitors were about 2% of the Japanese population, compared to almost nil today. The improvement in the goods and services balance should nudge the basic balance above 2% of GDP in the coming quarters. Net portfolio investments are accelerating, especially given the recent underperformance of Japanese equities (making them cheap), and positive real rates from longer-term Japanese corporate and government bonds.         United Kingdom Chart I-8UK Balance Of Payments The UK trade and current account balance is deteriorating again, on the back of a more tumultuous post-Brexit transition. This has nudged the basic balance into negative territory (Chart I-8). The strong rally in the pound has also chiselled away some of the competitive edge British goods commanded on a global landscape. Significant foreign direct investment will be necessary to prevent the pound from adjusting much lower. There is progress, as the Conservative government has signed some significant trade deals over the course of the year. This should assuage foreign investor concerns over the potential for market access, should they invest in UK production. Portfolio investment in the UK has rolled over, but this is likely to be temporary if global equity markets remain resilient. Real rates are also improving in the UK, which should stem bond outflows. The key for the pound in the coming years will be productivity improvements which will allow foreign investors to keep financing the trade deficit.         Canada Chart I-9Canada Balance Of Payments The Canadian basic balance has modestly improved, after being flat for over a decade. The improvement has been in the current account and is specifically driven by income receipts from Canada’s improving net international investment position (Chart I-9). Foreign direct investment has also remained resilient, and should remain so, given strong commodity prices. Canada is one of the largest exporters of crude oil, meaning the increase in petroleum prices will buffet the trade balance. In fact, since the 2020 lows, the monthly trade balance has recovered from almost negative C$6 billion to C$0.6 billion in April. Today, the basic balance stands at a surplus of 1% of GDP and should continue to improve.                   Australia Chart I-10Australia Balance Of Payments Australia sports the best improvement in both its trade and current account balance over the last few years. This has pushed the basic balance near a record 3.75% of GDP (Chart I-10). Australia’s long affair with a current account deficit is over. Investment in projects in the resource space are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. Australia’s comparative advantage in exports of LNG will likely be the next key driver of the trade balance, replacing coal shipments. This is consistent with the ESG megatrend. Net portfolio investment has been falling for years, but this just reflects Australia’s rising savings. In other words, the current account surplus is being recycled abroad. In short, the Aussie dollar has a large amount of running room, albeit, barring a tactical correction.             New Zealand Chart I-11New Zealand Balance Of Payments The New Zealand basic balance has been negative for many years, only recently going into balance (Chart I-11). The boom in agricultural prices has helped boost the trade balance into surplus, but this has not been sufficient to bring the current account into balance. Coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities have keep the current account in structural deficit. Portfolio investments are accelerating out of New Zealand. The last time they hit -8% of GDP was just after the financial crisis. It is not clear why foreign investors are shunning this rather defensive market, but high valuations may be playing a key role. Importantly, FDI inflows remain steady, near 1.75% of GDP. Going forward, New Zealand should continue to see modest improvement in its basic balance, especially relative to the US, supporting the kiwi.           Switzerland Chart I-12Switzerland Balance Of Payments Switzerland has had a structural uptrend in its trade balance for decades (Chart I-12). This has buffeted both the current account and the basic balance. It has also allowed the trade-weighted Swiss franc to outperform on a structural basis. In Q1, the current account surplus rose to CHF 16 billion, a 60% increase from Q1 2020, driven by an improvement in the goods trade balance. However, both primary and secondary income were a drag on the current account balance. The net international investment position also improved on the back of a net increase in foreign asset purchases. However, a strong dollar in Q1 reduced the net value of foreign currencies in the portfolio. The positive balance-of-payment backdrop continues to create a headache for the Swiss National Bank. CHF has been weak this year, and the SNB will likely continue to intervene in the foreign exchange markets to calm future appreciation in the franc. That said, we expect the trade-weighted franc to rise on a structural basis.          Norway Chart I-13Norway Balance Of Payments Norway’s trade balance was heavily hit by the COVID-19 crisis but is slowly recovering (Chart I-13). The trade surplus started to plunge sharply due to falling energy prices at the beginning of the lockdown. Going forward, the reopening of the global economy, especially Europe, will benefit Norwegian exports of oil and gas. Meanwhile, tepid investment in global oil and gas extraction over the past five years will ensure Norway’s terms of trade remains robust. This will especially be the case thanks to growing production from the new Johan Sverdrup field. From a more fundamental perspective, the krone will also benefit from positive income flows. Norway has one of the biggest NIIPs in the world, which generates large income receipts that skew heavily toward equity dividends. This characteristic strengthens the bond between the NOK and global equities, making it the perfect procyclical currency. On a structural basis, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome.   Sweden Chart I-14Sweden Balance Of Payments The Swedish current account balance has improved smartly in the last few quarters, boosting the basic balance to a surplus of over 5% of GDP. While the trade surplus has certainly improved, the primary income surplus has been the key driver (Chart I-14). FDI inflows have not had a strong impact on the basic balance. In terms of portfolio investment, this has turned negative as Riksbank purchases have crowded out investors. Income receipts have also needed to be recycled. In conclusion, the Swedish krona remains one of our favorite currencies due to its increasing basic balance surplus and its cheap valuation. We were stopped out of our long Nordic basket trade (NOK and SEK) against both the euro and the US dollar but will be looking to re-establish at more attractive levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Chart 13BGerman Greens Will Surprise To Upside We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Chart 17Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia

Highlights Entering 2H21, oil and metals' price volatility will rise as inventories are drawn down to cover physical supply deficits brought about by the re-opening of major economies ex-China. As demand increases and oil and metals supply become more inelastic, forward curves will backwardate further.  This will weaken commodity-price correlations with the USD and boost commodity-index returns. Going into next week's OPEC 2.0 meeting, the Kingdom of Saudi Arabia (KSA) and Russia likely will hold off on further production increases, until greater clarity around US-Iran negotiations and the return of Iran as a bona fide exporter is available. Chinese authorities will release 100k MT of copper, aluminum and zinc into tight domestic markets in July.  A two-day rally followed the news. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, following the ~ 230% move in crude oil and the ~ 100% rise copper prices.  Higher volatility will present buying opportunities for these ETFs  (Chart of the Week). We remain long commodity index exposure – S&P GSCI and COMT ETF – expecting steeper backwardations. We will go long the PICK ETF at tonight's close again, after being stopped out last week with a 23.9% return. Feature Heading into 2H21, industrial commodity markets will continue to tighten.  In the case of oil, this is caused by OPEC 2.0's production-management strategy – i.e., keeping supply below demand – and capital discipline among producers in the price-taking cohort.1 Base metals, on the other hand, are tightening because demand is recovering much faster than supply.2 Re-opening of major economies will boost refined-product demand in oil markets – e.g., gasoline and jet fuel – which will leave refiners little choice but to continue drawing on inventories to cover supply shortfalls in the near term (Chart 2). Chart of the WeekResources ETFs Follow Prices Higher Chart 2Refiners Will Continue Drawing Crude Investments Base metals – particularly copper and aluminum – will remain well bid in the face of constrained supply and higher consumption ex-China.  Despite China's widely anticipated decision to release strategic stockpiles of copper, aluminum and zinc next month into a tight domestic market – which we flagged last month – continued inventory draws will be required to cover physical deficits in these markets, particularly in copper (Chart 3).3 Chart 3Copper Inventories Will Draw As Demand Ex-China Rises Chart 4Steeper Backwardation, Higher Volatility Higher Vol On The Way As demand for industrial commodities increases and inventories continue to draw, forward curves will become more backwardated – i.e., material delivered promptly (next day or next week) will command a higher price than commodities delivered next month or next year: Consumers value current supply above deferred supply, and producers and merchants have to charge more to cover inventory replacement costs, which increase when prompt demand outstrips supply. The steepening of forward curves for industrial commodities will lead to higher price volatility in oil and metals markets, particularly copper: Demand will confront increasingly inelastic supply.  In this evolution, prices will be forced to allocate inelastic supply as demand increases.  Sometimes-sharp changes in price are required to equilibrate available supply with demand when this happens.  This can be seen clearly in oil markets, but it holds true for all storable commodities (Chart 4).4 Investment Implications Industrial commodity markets are entering a more volatile phase, which will be characterized by sharp price movements up and down over the short term, as demand continues to outpace supply. Our analysis suggests this is the beginning of a more volatile phase in industrial commodity markets.  The balance of risk in industrial commodity prices will remain to the upside as volatility increases. In the short term, fundamental imbalances can be addressed over a relatively short months-long horizon – i.e., OPEC 2.0 can release spare capacity over a 3-4 month interval to accommodate rising demand – so that price increases do not destroy demand as oil-exporters are rebuilding their fiscal balance sheets. Base metals markets will have a tougher time in the short run finding the supply to meet surging demand, but it can be done over the next year or so without prices getting to the point where demand-destruction sets in. Over the medium to long term, investor-owned oil and gas producers literally are being directed by policymakers, shareholders and courts toward an extended wind-down of production and investment in future production.  Markets have been pricing through just such a situation in the post-COVID-19 world, with OPEC 2.0 managing supply against falling demand and still managing to reduce inventories significantly.  If the world follows the IEA's pathway to a decarbonized future – in which no investment in new oil or gas production is required after 2025 – this will become the status quo for these markets going forward.5 Metals producers, on the other hand, are being encouraged to increase marketable supply at a rapid pace to accommodate demand driven by the build-out of renewable energy – chiefly wind and solar – and the grids that will be required to move this energy. Producers, however, remain reluctant to do so, fearing their capex investment to build out supply will produce physical surpluses that depress returns, similar to the last China-led commodity super-cycle. Supplying the necessary base metals to make this happen will be difficult at best, according to Ivan Glasenberg, CEO at Glencore.  At this week's Qatar Economic Forum, he said copper supply will have to double between now and 2050 to meet expected demand for this critical metal.  “Today, the world consumes 30 million tonnes of copper per year and by the year 2050, following this trajectory, we’ve got to produce 60 million tonnes of copper per year,” he said.  “If you look at the historical past 10 years, we’ve only added 500,000 tonnes per year … Do we have the projects? I don’t think so. I think it will be extremely difficult.”6 The volatility we are expecting in oil, gas and base metals prices, will present buy-the-dip opportunities in related equities vehicles.  Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, matching the ~ 230% move in crude oil and the ~ 100% rise in copper prices.  We remain long commodity index exposure – S&P GSCI, which is up 5.9% and the COMT ETF, which is up 7.6% – expecting steeper backwardations.  The trailing stop on our MSCI Global Metals & Mining Producers ETF (PICK) position recommended 10 December 2020 was elected, which stopped us out with a gain of 23.9%.  We are getting long the PICK again at tonight's close.   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 Commercial crude oil stocks in the US (ex-SPR barrels) fell 7.6mm barrels w/w in the week ended 18 June 2021, according to the US EIA. Including products, US crude and product inventories were down 5.8mm barrels. US domestic crude oil production was down 100k b/d, ending the week at 11.1mm b/d. Overall product supplied, the EIA's proxy for refined-product demand, was up 180k b/d at 20.75mm b/d, which is 129k b/d below 2019 demand for the same period. At 9.44mm b/d, gasoline demand was just below comparable 2019 consumption of 9.47mm b/d, while jet-fuel demand remains severely depressed vs. comparable 2019 consumption at 1.58mm b/d (vs. 1.92mm b/d).  Distillate demand (e.g., diesel fuel) for the week ended 18 June 2021 was 3.95mm b/d vs. 3.97mm b/d for the comparable 2019 period. Base Metals: Bullish Benchmark spot iron ore (62% Fe) prices are holding above $210/MT in trading this week, as demand for the steel input remains strong in China (Chart 5). The Chinese Communist Party (CCP) increased its level of intervention in the iron ore market this week, launching investigations into “malicious speculation,” vowing to “severely punish” anyone found to be engaged in such behavior, according to ft.com.7 Benchmark iron ore prices hit $230/MT in May. We continue to expect exports from Brazil to pick up in 2H21, which will push prices lower in 2H21. Precious Metals: Bullish In the aftermath of last Wednesday’s FOMC meeting gold prices lost nearly $86/oz (Chart 6). Our colleagues at BCA Research's USBS believe markets are paying too much attention to the Fed’s dot plots, and not to the central bank’s verbal guidance.8 Originally, the Fed stated that it will only start raising interest rates once a checklist of three conditions have been met. This checklist includes guidance on actual and expected inflation rates and the labor market. Gold prices did not react to Chair Powell's testimony before the House Select Subcommittee on the Coronavirus Crisis. Ags/Softs: Neutral US spring wheat prices are rallying on the back of dry weather in the northern Plains, while forecasts for benign crop weather in the Midwest pressured soybeans lower this week, according to successfulfarming.com. Chart 5 Chart 6     Footnotes 1     Please see our most recent oil price forecasts published last week in Balance Of Risks Tilts To Higher Oil Prices.  It is available at ces.bcaresearch.com. 2     Please see A Perfect Energy Storm On The Way published on June 3, 2021 for further discussion. 3    Please see Less Metal, More Jawboning published on May 27, 2021, which flagged China's likely decision to release strategic stockpiles of base metals. 4    Chart 4 shows implied volatility as a function of the slope of the forward curve, i.e., the difference between the 1st- and 13th-nearby futures divided by the 1st-nearby future vs implied volatilities for Brent and WTI options.  This modeling extends Kogan et al (2009), mapping realized volatilities calculated using historical settlements of crude oil futures against the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009), "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64:3, pp. 1345-1375. 5    Please see fn 2's discussion of the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector beginning on p. 5 under The Case For A Carbon Tax. 6    Please see Copper supply needs to double by 2050, Glencore CEO says published on June 23, 2021 by reuters.com.  Of course, being a copper producer with large-scale base-metals projects due to come on line in the next year or so, Mr. Glasenberg could be talking his book, but as Chart 3 shows, copper has been and likely will be in physical deficits for years. 7     Please see China cracks down on iron ore market, published by ft.com on June 21, 2021. 8    Please see How To Re-Shape The Yield Curve Without Really Trying, published on June 22, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

The S&P 500 raced through the seasonally strong spring months rising by more than 10% from early March. Now, there is the chance that the US equity market will find it difficult grinding higher if the proverbial “sell in May and go away” attitude kicks in. As a reminder, we also recently rotated into quality growth names and took down some of the high-octane cyclical sectors such as the S&P steel index. Both of these moves should protect our portfolio if volatility comes back this summer. Bottom Line: If history is any guide, we expect market to be range bound throughout the summer.