Emerging Markets

Special Report

Highlights The Greens are likely to win control of Germany’s government in the September 26 federal elections. At least they will be very influential in the new coalition. Germany has achieved may of its long-term geopolitical goals within the EU. There is consensus on dovish monetary and fiscal policy and hawkish environmental policy. The biggest changes will come from the outside. The US and Germany have a more difficult relationship. While they both oppose Russian and Chinese aggression, Germany will resist American aggression. The Christian Democrats have a 65% chance of remaining in government which would limit the Greens’ controversial and ambitious tax agenda. The 35% chance of a left-wing coalition will frontload fiscal stimulus for the sake of recovery. The economy is looking up and a Green-led fiscal easing would supercharge the recovery. However, coalition politics will likely fail to address Germany’s poor demography, deteriorating productivity, and large excess savings. On a cyclical basis, overweight peripheral European bonds relative to bunds; EUR/USD; and Italian and Spanish stocks relative to German stocks. Feature Chart 1Germans Turn To A Young Woman And A Green Germany is set to become the first major country to be led by a green party. At very least the German election on September 26 will see an upset in which the ruling party under-performs and the Greens over-perform (Chart 1). At 30%, online betting markets are underrating the odds that Annalena Baerbock will become the first Green chancellor in 2022 – and the first elected chancellor to hail from a third party (Chart 2). The “German question” – the problem of how to unify Germany yet keep peace with the neighbors – lay at the heart of Europe for the past two centuries but today it appears substantially resolved: a peaceful and unified Germany stands at the center of a peaceful and mostly unified Europe. There are a range of risks on the horizon but this positive backdrop should be acknowledged. Chart 2Market Waking Up To Baerbock’s Bid For Chancellorship All of the likeliest scenarios for the German election will reinforce the current situation by perpetuating policies that aim for Euro Area solidarity. Even the green shift is already well underway, though a Green-led government would supercharge it. Nevertheless this year’s election is important because it heralds a leftward shift in Germany and will shape fiscal, energy, industrial, and trade policy for at least the coming four years. A left-wing sweep would generate equity market excitement in the short run – a positive fiscal surprise to supercharge the post-pandemic rebound – but over the long run it would bring greater policy uncertainty because it would cause a break with the past and possibly a structural economic shift (Chart 3). The Greens are in favor of substantial increases in taxation and regulation as well as big changes in industrial and energy policy. In the absence of a left-wing sweep, coalition politics will be a muddle and Germany’s existing policies will continue. Chart 3German Policy Uncertainty On The Rise Regardless of what happens within Germany, the geopolitical environment is increasingly dangerous. Germany will try to avoid getting drawn into the US’s great power struggles with Russia and China but it may not have a choice. Germany’s Geopolitics The difficulty of German unification stands at the center of modern European history. Because of the large and productive German-speaking population, unification in 1871 posed a security threat to the neighbors, culminating in the world wars. The peaceful German reunification after the Cold War created the potential for the EU to succeed and establish peace and prosperity on the continent. This arrangement has survived recent challenges. Germany’s relationship with the EU came under threat from the financial crisis, the Arab Spring and immigration influx, Brexit, and President Trump’s trade tariffs. But in the end these events cemented the reality that German and Europe are strengthening their bonds in the face of foreign pressures. Germany achieved what it had long sought – preeminence on the continent – by eschewing a military role, sticking to France economically, and avoiding conflict with Russia. Since Germany has achieved many of its long-sought strategic objectives it has not fallen victim to a nationalist backlash over the past ten years like the US and United Kingdom. However, Germany is not immune to populism or anti-establishment sentiment. The two main political blocs, the Christian Democrats and the Democratic Socialists, have suffered a loss of popular support in recent elections, forcing them into a grand coalition together. Anti-establishment feeling in Germany has moved the electorate to the left, in favor of the Greens. The Greens have risen inexorably over the past decade and have now seized the momentum only five months before an election (Chart 4). Yet the Greens in Germany are basically an establishment political party. They participate in 11 out of 16 state governments and currently hold the top position in Baden-Württemberg, Germany’s third most populous and productive state. From 1998-2005 they participated in government, getting their hands dirty with neoliberal structural reforms and overseas military deployments. Moreover the Greens cannot rule alone but will have to rule within a coalition, which will mediate their more controversial policies. Chart 4Greens Surge, Christian Democrats Falter Today Germany is in lock step with France and the EU by meeting three key conditions: full monetary accommodation (the German constitutional court’s challenges to the European Central Bank are ineffectual), full fiscal accommodation (Chancellor Angela Merkel agreed to joint debt issuance and loose deficit controls amid the COVID-19 crisis as well as robust green energy policies), and full security accommodation (German rearmament exists within the context of NATO and European security aspirations are undertaken in lock-step with the French). These conditions will not change in the 2021 election even assuming that the Greens take power at the head of a left-wing coalition. Bottom Line: Germany has virtually achieved its grand strategic aims of unifying and ruling Europe. No German government will challenge this situation and every German government will strive to solidify it. The greatest risks to this setup stem from abroad rather than at home. The Return Of The German Question? Germany’s geopolitical position can be summarized by Chart 5, which shows popular views toward different countries and institutions. The Germans look positively upon the EU and global institutions like the United Nations and less so NATO. They look unfavorably upon everything else. They take an unfavorable view toward Russia, but not dramatically so, which shows their lack of interest in conflict with Russia – they do not want to be the battleground or the ramparts of another major European war. They dislike the United States and China even more, and equally. Even if attitudes toward the US have improved since the 2020 election the net unfavorability is telling. Chart 5Germany More Favorable Toward Russia Than US? Since the global financial crisis, and especially Russia’s invasion of Ukraine in 2014, Germany has built up its military. This buildup is taking place under the prodding of the United States and in step with NATO allies, who are reacting to Russia’s military action to restore its sphere of influence in the former Soviet space (Chart 6). Germany’s military spending still falls short of NATO’s 2% of GDP target, however. It will not be seen as a threat to its neighbors as long as it remains integrated with France and Europe and geared toward deterring Russia. Chart 6Germany And NATO Increase Military Spending Chart 7Watch Russo-German Relations For Cracks In Europe’s Edifice Russia’s aggressiveness should continue to drive the Germans and Europeans into each other’s arms. This could change if Putin pursues diplomacy over military coercion, for then he could split Germany from eastern Europe. The possibility is clear from Russia’s and Germany’s current insistence on completing the Nord Stream 2 pipeline despite American and eastern European objections. The pipeline is set to be completed by September, right in time for the elections – in no small part because the Greens oppose it. If the US insists on halting the pipeline then a crisis will erupt with Russia that will humiliate Merkel and the Christian Democrats. But the US may refrain from doing so in the face of Russian military threats (odds are 50/50). The Russian positioning over 100,000 troops on the border with Ukraine this year – and now reportedly ordering them to return to base by May 1 – amounts to a test of Russo-German relations. Putin can easily expand the Russian footprint in Ukraine and tensions will remain elevated at least through the Russian legislative elections in September. Germans would respond to another invasion with sanctions, albeit likely watering down tougher sanctions proposed by the Americans. What would truly change the game would be a Russian conquest of all of Ukraine. This is unlikely – precisely because it would unite Germany, the Europeans, and the Americans solidly against Russia, to its economic loss as well as strategic disadvantage (Chart 7). China’s rise should also keep Germany bound up with Europe. The Germans fear China’s technological and manufacturing advancement, including Chinese involvement in digital infrastructure and networks. The Greens are critical of the way that carbon-heavy Chinese goods undercut the prices of carbon-lite German goods. Baerbock favors carbon adjustment fees, a pretty word for tariffs. However, the Germans want to maintain business with China and are not very afraid of China’s military. Hence there is a risk of a US-German split over the question of China. If Germany should consistently side with Russia and China over US objections then it risks attracting hostile attention from the US as well as from fellow Europeans, who will eventually fear that German power is becoming exorbitant by forming relations with giants outside the EU. But this is not the leading risk today. The US is courting Germany and seeking to renew the trans-Atlantic alliance. Meanwhile Germany needs US support against Russia’s military and China’s trade practices. US-German relations will improve unless the US forces Germany into an outright conflict with the autocratic powers. Bottom Line: The US and Germany have a more difficult relationship now than in the past but they share an interest in deterring Russian aggression and Chinese technological and trade ambitions. Biden’s attempt to confront these powers multilaterally is limited by Germany’s risk-aversion. Scenarios For The 2021 Election There are several realistic scenarios for the German election outcome. Our expectation that the Greens will form a government stems from a series of fundamental factors. Opinion polling has now clearly shifted in favor of our view, with the Greens gaining the momentum with only five months to go. Grouping the political parties into ideological blocs shows that the race is a dead heat. Our bet is that momentum will break in favor of the opposition Greens, which we explain below. Meanwhile the Free Democrats should perform well, stealing votes from the Christian Democrats. The right-wing Alternative für Deutschland (AfD), while not performing well, is persistent enough to poach some votes from the Christian Democrats. These are “lost” votes to the conservatives as none of the parties will join it in a coalition (Chart 8). Chart 8Germany's Median Voters Shifts To the Left The Christian Democrats bear all the signs of a stale and vulnerable government. They have been in power for 16 years and their performance in state and federal elections has eroded recently, including this year (Table 1). The public is susceptible to the powerful idea that it is time for a change. Chancellor Merkel’s approval rating is still around 60%, but in freefall, and her successful legacy is not enough to save her party, which is showing all the signs of panic: succession issues, indecision, infighting, corruption scandals. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated (Table 2).1 Table 1AChristian Democrats Fall, Greens Rise, In Recent State Elections Table 1BChristian Democrats Fall, Greens Rise, In Recent State Elections Table 2Policy Platforms Of The Green Party The fact that Christian Democrats and their Bavarian sister party, the Christian Social Union, saw such a tough race for chancellor candidate is an ill omen. Moreover the party’s elites went for the safe choice of Merkel’s handpicked successor, Armin Laschet, over the more popular Markus Soeder (Chart 9), in a division that will likely haunt the party later this year. Chart 9Christian Democrats And Christian Social Union Divided Ahead Of Election Laschet has received a bounce in polls with the nomination but it will be temporary. He has not cut a major figure in any polling prior to now. Chart 10Dissatisfaction Points To Government Change He has quarreled openly with Merkel and the coalition over pandemic management. He was not her first choice of successor anyway – that was Annagret Kramp-Karrenbauer, who fell from grace due to controversy over the faintest hint of cooperation with the AfD. There is a manifest problem filling Merkel’s shoes. Even more important than coalition infighting is the fact that Germany, like the rest of the world, has suffered a historic shock to its economy and society. The pandemic and recession were then aggravated by a botched vaccine rollout. General dissatisfaction is high, another negative sign for the incumbent party (Chart 10). Of course, the election is still five months away. The vaccine will make its way around, the economy will reopen, and consumers will look up – see below for the very positive macro upturn that Germany should expect between now and the election. Voters have largely favored strict pandemic measures and Merkel will have long coattails. This Christian Democrats and Christian Social Union have ruled modern Germany for all but 15 years and have not fallen beneath 33% of the popular vote since reunification. The Greens have frequently aroused more energy in opinion polling than at the voting booth. With these points in mind, we offer the following election scenarios with our subjective probabilities: Green-Red-Red Coalition – Greens rule without Christian Democrats – 35% odds. Green-Black Coalition – Greens rule with Christian Democrats – 30% odds. Black-Green Coalition – Christian Democrats rule with Greens – 25% odds. Grand Coalition (Status Quo) – Christian Democrats rule without Greens – 10% odds. Our subjective probabilities are based on the opinion polls and online betting cited above but adjusted for the Greens’ momentum, the Christian Democrats’ internal divisions, the “time for change” factor, and the presence of a historic exogenous economic and social shock. Geopolitical surprises could occur before the election but they would most likely reinforce the Greens, since they have taken a hawkish line against Russia and China. Bottom Line: The Greens are likely to lead the next German government but at very least they will have a powerful influence. Policy Impacts Of Election Scenarios The makeup of the ruling coalition will determine the parameters of new policy. Fiscal policy will change based on the election outcome – both spending and taxes. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated.2 The Greens’ idea is to “steer” the rebuilding process through environmental policy. But if the left lacks a strong majority then the Greens’ more controversial and punitive measures will not get through. Transformative policies will weigh heavily on the lower classes (Chart 11). Chart 11Ambitious Climate Policy Will Face Resistance The policy dispositions of the various chancellor candidates help to illustrate Germany’s high degree of policy consensus. Table 3 looks at the candidates based on whether they are “hawkish” (active or offensive) or “dovish” (passive or defensive) on a given policy area. What stands out is the agreement among the different candidates despite party differences. Nobody is a fiscal or monetary hawk. Only Baerbock can be classified as a hawk on trade.3 Nobody is a hawk on immigration. Nearly everyone is a hawk on fighting climate change. And attitudes are turning more skeptical of Russia and China, though not outright hawkish. Table 3Policy Consensus Among German Chancellor Candidates Germany will not abandon its green initiatives even if the Greens underperform. The current grand coalition pursued a climate package due to popular pressure even with the Greens in opposition. Germans are considerably more pro-environment even than other Europeans (Chart 12). The green shift is also happening across the world. The US is now joining the green race while China is doubling down for its own reasons. See the Appendix for current green targets and measures, which have been updated in the wake of a slew of announcements before Biden’s Earth Day climate summit on April 22-23. Chart 12Germans Care Even More About Environment Than Other Europeans Any coalition will raise spending more than taxes since it will be focused on post-COVID economic recovery. There has been a long prelude to Germany’s proactive fiscal shift – it has staying power and is not to be dismissed. A Christian Democratic coalition would try to restore fiscal discipline sooner than otherwise but there is only a 5% chance that it will have the power to do so according to the scenarios given above. The rest of Europe will be motivated to spend aggressively while EU fiscal caps are on hold in 2022, especially if the German government is taking a more dovish turn. Even more than the US and UK, Germany is turning away from the neoliberal Washington Consensus. But Germans are not experiencing any kind of US-style surge of polarization and populism. At least not yet. It may be a risk over the long run, depending on the fate of the Christian Democrats, the AfD, and various internal and external developments. Bottom Line: Germany has a national consensus that consists of dovish monetary, fiscal, trade, and immigration policies and hawkish (pro-green) environmental policy. Germany is turning less dovish on geopolitical conflicts with Russia and China. Given that a coalition government is likely, this consensus is likely to determine actual policy in the wake of this year’s election. A few things are clear regardless of the ruling coalition. First, Germany is seeking domestic demand as a new source of growth, to rebalance its economy and deepen EU integration. Second, Germany is accelerating its green energy drive. Third, Germany cannot accept being in the middle of a new cold war with Russia. Fourth, Germany has an ambivalent policy on China. Germany’s Macro Outlook Even before considering the broader fiscal picture, the outlook for German economic activity over the course of the coming 12 to 24 months was already positive. Our base case scenario for the September election, which foresees a coalition government led by the Green Party, only confirms this optimistic view. However, Germany is still facing significant long-term challenges, and, so far, there has not been a political consensus to address these structural headwinds adequately. The Greens offer some solutions but not all of their proposals are constructive and much will depend on their parliamentary strength. Peering Into The Near-Term… Germany’s economy is set to benefit from the continued recovery of the global business cycle, which is a view at the core of BCA Research’s current outlook.4 Germany remains a trading and manufacturing powerhouse, and thus, it will reap a significant dividend from the continued global manufacturing upswing. Manufacturing and trade amount to 20% and 88% of Germany’s GDP, the highest percentage of any major economy. Alternatively, according to the OECD, foreign demand for German goods accounts for nearly 30% of domestic value added, a share even greater than that for a smaller economy like Korea (Chart 13). Moreover, road vehicles, machinery and other transport equipment, as well as chemicals and related products, account for 53% of Germany’s exports. These products are all particularly sensitive to the global business cycle. They will therefore enhance the performance of the German economy over the next two years. Trade with the rest of Europe constitutes another boost to Germany’s economy going forward. Shipments to the euro area and the rest of the EU account for 34% and 23% of Germany’s exports, or 57% overall. Right now, the lagging economy of Europe is a handicap for Germany; however, Europe has more pent-up demand than the US, and the consumption of durable goods will surge once the vaccination campaign progresses further (Chart 14). This will create a significant boon for Germany, since we expect European consumption to pick up meaningfully over the coming 12 to 18 months.5 Chart 13Germany Depends On Global Trade Chart 14Europe Has More Pent-Up Demand Than The US Chart 15Vaccination Progress Domestic forces also point toward a strong Germany economy, not just foreign factors. The pace of vaccination is rapidly accelerating in Germany (Chart 15). The recent announcement of 50 million additional doses purchases for the quarter and up to 1.8 billion more doses over the next two years by the EU points to further improvements. A more broad-based vaccination effort will catalyze underlying tailwinds to consumption. German household income will also progress significantly. The Kurzarbeit program was instrumental in containing the unemployment rate during the crisis, which only peaked at 6.4% from 5% in early 2020. However, the program could not prevent a sharp decline in total hours worked of 7%, since by definition, it forced six million employees to work reduced hours (Chart 16). One of the great benefits of the program is that it prevents a rupture of the link between workers and employers. Thus, the economy suffers less frictional unemployment as activity recovers and household income does not suffer long lasting damage. Meanwhile, the German government is likely to extend the support for households and businesses as a result of the delayed use of the debt-brake. The Greens propose revising the debt brake rather than restoring it in 2022 like the conservatives pledge to do. Chart 16Kurtzarbeit Saved The Day The balance-sheet strength of German households means that they will have the wherewithal to spend these growing incomes. Residential real estate prices are rising at an 8% annual pace, which is pushing the asset-to-disposable income ratio to record highs. Meanwhile, the debt-to-assets ratio, and the level of interest rates are also very low, which means that the burden of serving existing liabilities is minimal (Chart 17). In this context, durable goods spending will accelerate, which will lift overall cyclical spending, even if German households do not spend much of the EUR120 billion in excess savings built up over the past year. As Chart 18 shows, while US durable goods spending has already overtaken its pre-COVID highs, Germany’s continues to linger near its long-term trend. Thus, as the economy re-opens this summer, and income and employment increase, the concurrent surge in consumer confidence will allow for a recovery in cyclical spending. Chart 17Strong Household Balance Sheets Chart 18Germany Too Has More Pent-up Demand Than The US Chart 19Positive Message From Many Indicators Various economic indicators are already pointing toward the coming German economic boom.Manufacturing orders are strong, and economic sentiment confidence is rising across most sectors. Meanwhile, consumer optimism is forming a trough, and new car registrations are climbing rapidly. Most positively, the stocks of finished goods have collapsed, which suggests that production will be ramped up to fulfill future demand (Chart 19). Bottom Line: The German economy is set to accelerate in the second half of the year and into 2022. As usual, Germany will enjoy a healthy dividend from robust global growth, but the expanding vaccination program, as well durable employee-employer relations, strong household balance sheets, and significant pent-up demand for durable goods will also fuel the domestic economy. Our base case scenario that fiscal policy will remain accommodative in the wake of a political shift to the left in Berlin in September will only supercharge this inevitable recovery. … And The Long-Term In contrast to the bright near-term perspective, the long-term outlook for the German economy remains poor. The policies of any new ruling coalition are unlikely to address the problems of Germany’s poor demography, deteriorating productivity, and large excess savings. There is potential for a productivity boost in the context of a global green energy and high-tech race but for now that remains a matter of speculation. The most obvious issue facing Germany is its ageing population, counterbalanced by its fertility rate of only 1.6. Over the course of the next three decades, Germany’s dependency ratio will surge to 80%, driven by an increase in the elderly dependency ratio of 20% (Chart 20). The working age population is set to decline by 18% by 2050, which will curtail potential GDP growth. The outlook for German productivity growth is also poor. Germany’s productivity growth has been in a long-term decline, falling from 5% in 1975 to less than 1% in 2019. Contrary to commonly-held ideas, from 1999 to 2007, German labor productivity growth has only matched that of France or Spain; since 2008, it has lagged behind these two nations, although it has bested Italy. One crucial reason for Germany’s uninspiring productivity performance is a lack of investment. Some of this reflects the country’s austere fiscal policy. For example, in 2019, Germany’s public investment stood at 2.4% of GDP, which compares poorly to the OECD’s average of 3.8%, or even to that of the US, where public investment stood at 3.6% of GDP. This poor statistic does not even account for the depreciation of the German public capital stock. Since the introduction of the euro, net public investment has averaged 0.03% of GDP. The biggest problem remains at the municipal level. From 2012 to 2019, federal and state level net investment averaged 0.2% of GDP, while municipal net investment subtracted 0.2% of GDP on average. Hopefully, the new government will be able to address this deficiency of the German economy. The Greens are most proactive but they will face obstacles. The bigger problem for German productivity is corporate capex. Corporate investments have been low in this country. Since the introduction of the euro, the contribution of capital intensity to productivity in Germany has equaled that of Italy and has underperformed France and Spain. As a result, the age of the German capital stock is at a record high and stands well above the US or Eurozone average (Chart 21). Chart 20Germany Has Poor Demographics Chart 21Germany's Capital Stock Is Ageing The make-up of Germany’s capex aggravates the productivity-handicap. According to a Bundesbank study, the contribution to labor productivity from information and communication technology (ICT) capital spending has averaged 0.05 percentage points annually from 2008 to 2012. On this metric, Germany lagged behind France and the US, but still bested Italy. From 2013 to 2017, the contribution of ICT investment to productivity fell to 0.02 percentage points, still below France and the US, but in line with Italy. Looking at the absolute level of ICT or knowledge-based capital (KBC) investment further highlights Germany’s challenge. In 2016, total investment in ICT equipment, software and database, R&D and intellectual property products, and other KBC assets (which include organizational capital and training) represented less than 8% of GDP. In France, the US, or Sweden, these outlays accounted for 11%, 12%, and 13% of GDP, respectively (Chart 22, top panel). This lack of investment directly hurts Germany’s capacity to innovate. The bottom panel of Chart 22 shows that, for the eight most important categories of ICT patents (accounting for 80% of total ICT patents), Germany remarkably lags behind the US, Japan, Korea, or China. Chart 22Germany Lags In ICT investment A major source of Germany’s handicap in ICT and KBC investment comes from small businesses, which have been particularly reluctant to deploy capital. A study by the OECD shows that, between 2010 and 2019, the gap of ICT tools and activities adoption between Germany’s small and large companies deteriorated relative to the OECD average (Chart 23). The lack of venture capital investing probably exacerbates these problems. In 2019, venture capital investing accounted for 0.06% of Germany’s GDP. This is below the level of venture investing in France or the UK (0.08% and 0.1% of GDP, respectively), let alone South Korea, Canada, Israel, or the US (0.16%, 0.2%, 0.4% and 0.65%, respectively). The Greens claim they will create new venture capital funds but their capability in this domain is questionable. Chart 23The Lagging ICT Capabilities Of Small German Businesses Since Germany’s productivity growth is likely to remain sub-par compared to rest of the OECD and to lag behind even that of France or the UK, the only way for Germany to protect its competitiveness will be to control costs. This means that Germany cannot allow its recent loss of competitiveness to continue much further (Chart 24). Thus, low productivity growth will limit Germany’s real wages. Chart 24Germany's Competitiveness Is Declining This wage constraint will negatively impact consumption. Beyond a pop over the coming 12 to 24 months, German consumption is likely to remain depressed, as it was in the first decade and a half of the century, following the Hartz IV labor market reforms that also hurt real wages. The Greens for their part aim to boost welfare payments, raise the minimum wage, and reduce enforcement of Hartz IV. Bottom Line: German excess savings will remain wide on a structural basis. Without a meaningful pick-up in capex, German nonfinancial businesses will remain net lenders. Meanwhile, households that were worried about their financial future in a world of low real-wage growth will also continue to save a significant share of their income. Consequently, the excess savings Germany developed since the turn of the millennia are here to stay (Chart 25). In other words, Germany will continue to sport a large current account surplus and exert a deflationary influence on Europe and the rest of the world. The policy prescribed by the various parties contesting the September election will not necessarily result in new laws that will reverse the issues of low capex and low ICT investment. The Greens will worsen the over-regulation of the economy. Barring a policy revolution that succeeds in all its aims (a tall order), we can expect more of the same for Germany – that is, a slowly declining economy. Chart 25Too Much Savings, Not Enough Investments Chart 26Germany Scores Well On Renewable Power That being said, some bright spots exist. Germany is becoming a leader in renewable energy, and it can capitalize on the broadening of this trend to enlarge its export market (Chart 26). Investment Implications Bond Markets The economic outlook for Germany and the euro area at large is consistent with the underweighting of German bunds within European fixed-income portfolios. Bunds rank among the most expensive bond markets in the world, which will make them extremely vulnerable to positive economic surprise in Europe later this year, especially if Germany’s fiscal policy loosens up further in the wake of the September election (Chart 27). Moreover, easier German fiscal policy should help European peripheral bonds, especially the inexpensive Italian BTPs that the ECB currently buys aggressively. Thus, we continue to overweight BTPs, and add Greek and Portuguese bonds to the list. Chart 27German Bunds Are Expensive Chart 28German Yields Already Embed Plenty Pessimism About Europe Relative to US Treasurys, the outlook for Bunds is more complex. On the one hand, the ECB will not tighten policy as much as the Fed later this cycle; moreover, European inflation is likely to remain below US levels this year, as well as through the business cycle. On the other hand, Bunds already embed a significantly lower real terminal rate proxy and term premium than Treasury Notes (Chart 28). Netting it all out, BCA Research Global Fixed Income Strategy service believes Bunds should outperform Treasurys this year, because they have a lower beta, which is a valuable feature in a rising yield environment.6 We will closely monitor risks around this view, because it is likely that the European economic recovery will be the catalyst for the next up leg in global yields, in which case German bunds could temporarily underperform. On a structural basis, as long as Germany’s productivity issues are not addressed by Berlin, German Bunds are likely to remain an anchor for global yields. Germany will remain awash in excess savings, which will act as a deflationary anchor, while also limiting the long-term upside for European real rates. Excess savings results in a large current account surplus; thus, Germany will continue to export its savings abroad and act as a containing factor for global yields. The Euro The medium-term outlook points to significant euro upside. Our expectation of a European and German positive growth surprise over the coming 12 months is consistent with an outperformance of the euro. The fact that investors have been moving funds out of the Eurozone and into the US at an almost constant rate for the past 10 years only lends credence to this argument (Chart 29). Our view on Germany’s fiscal policy contributes to the euro’s luster. Greater German budget deficits help European economic activity and curtail risk premia across the Eurozone. This process is doubly positive for the euro. First, lower risk premia in the periphery invite inflows into the euro area, especially since Greek, Portuguese, Italian, or Spanish yields offer better value than alternatives. Second, stronger growth and lower risk premia relieve pressure on the ECB as the sole reflator for the Eurozone. At the margin, this process should boost the extremely depressed terminal rate proxy for Europe and help EUR/USD. Robust global economic activity adds to the euro’s appeal, beyond the positive domestic forces at play in Europe. The dollar is a countercyclical currency; thus, global business cycle upswings coincide with a weak USD, which increases EUR/USD’s appeal. Nonetheless, if the boost to global activity emanates from the US, then the dollar can strengthen. This phenomenon was at play in the first quarter of 2021. However, the global growth leadership is set to move away from the US over the next 12 months, which implies that the normal inverse relationship between the dollar and global growth will reassert itself to the euro’s benefit. The European balance of payments dynamics will consolidate the attraction of the euro. Germany’s and the Eurozone’s current account surplus will remain wide, especially in comparison to the expanding twin deficit plaguing the US. Beyond the next 12 to 24 months, the lack of structural vigor of Germany’s and Europe’s economy is likely to shift the euro into a safe-haven currency, like the yen and the Swiss franc. A strong balance of payments and low interest rates (all symptoms of excess savings) are the defining features of funding currencies, and will be permanent attributes of the euro area if reforms do not address its productivity malaise. The Eurozone’s net international position is already rising and its low inflation will put a structural upward bias to the Euro’s purchasing power parity estimates (Chart 30). Those developments have all been evident in Japan and Switzerland, and will likely extinguish the euro’s pro-cyclicality as time passes. Chart 29Investors Already Underweight European Assets Chart 30Upward Bias In The Euro's Fair Value Chart 31Germany Has Not Outperformed The Rest Of The Eurozone German Equities In absolute terms, the DAX and German equities still possess ample upside over the next 12 to 24 months. BCA Research is assuming a positive stance on equities, and a high beta market like Germany stands to benefit.7 Moreover, the elevated sensitivity to global economic activity of German equities accentuate their appeal. BCA Research likes European stocks, and German ones are no exception.8 The more complex question is how to position German equities within a European stock portfolio. After massively outperforming from 2003 to 2012, German equities have moved in line with the rest of the Eurozone ever since (Chart 31). Moreover, German equities now trade at a discount on all the major valuation metrics relative to the rest of the Eurozone (Chart 31, bottom panel). The global macro forces that dictate the outlook for German equities relative to the rest of the Eurozone are currently sending conflicting messages. On the one hand, German equities normally outperform when commodity prices rally or when the euro appreciates (Chart 32). On the other hand, however, German equities also underperform when global yields rise, or following periods when Chinese excess reserves fall, such as what we are witnessing today. With this lack of clarity from global forces, the answer to Germany’s relative performance question lies within European economic dynamics. Germany is losing competitiveness relative to the rest of the Eurozone (Chart 24 page 22) which suggests that German stocks will benefit less than their peers from a stronger euro in comparison to their performance in the last decade. Moreover, German equities outperform when the German manufacturing PMI increases relative to that of the broad euro area. The gap between the German and euro area manufacturing PMI stands near record highs and is likely to narrow as the rest of the Eurozone catches up. This should have a bearing on the performance of German stocks (Chart 33). Chart 32Mixed Global Backdrop For Germany's Relative Performance Chart 33A European Economic Catch-Up Would Hurt German Equities Finally, sectoral dynamics may prove to be the ultimate arbiter. Table 4 highlights the limited difference in sectoral weightings between Germany and the rest of the Eurozone, which helps explain the stability in the relative performance over the past nine years. However, the variance is greater between Germany and specific European nations. In this approach, BCA’s negative stance on growth stocks correlates with an overweight of Germany relative to the Netherlands. Moreover, our positive outlook on financials and bond yields suggests that Germany should underperform Italian and Spanish stocks. Table 4Sectoral Breakdown Across Europe Major Bourses   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Appendix: Global Climate Policy Commitments Footnotes 1 See Matthew Karnitschnig, "German Conservatives Mired In ‘The Swamp,’" Politico, March 24, 2021, politico.eu. 2 The Greens are interested in a range of taxes, including a carbon tax, a digital services tax, and a financial transactions tax. They are also interested in industrial quotas requiring steel and car makers to sell a certain proportion of carbon-neutral steel and electric vehicles. See an excellent interview with Ms. Baerbock in Ileana Grabitz and Katharina Schuler, "I don’t have to convert the SUV driver in Prenzlauer Berg," Zeit Online, January 2, 2020, zeit.de. 3 See her comments to Zeit Online. 4 Please see BCA Research Global Investment Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 5 Please see BCA Research European Investment Strategy Special Report "A Temporary Decoupling", dated April 5, 2021, available at eis.bcareseach.com. 6 Please see BCA Research Global Fixed Income Strategy Strategy Report "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcareseach.com. 7 Please see BCA Research Global Income Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 8 Please see BCA Research European Income Strategy Strategy Report "Time And Attraction", dated April 12, 2021, available at eis.bcareseach.com.

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Special Report

Highlights EM banks will underperform their DM peers in the next six months due to worsening relative NPL dynamics and shrinking net interest margins. EM banks will either continue experiencing rising NPLs and moribund loan demand due to restrictive lending rates or will have to reduce their lending rates, which will considerably shrink their net interest margins. In both scenarios, EM bank profits will be damaged. Besides, EM is facing an unfriendly macro cocktail of booming US growth and a slowing China. This could cause a capital exodus from EM in the coming months depressing EM currencies and precluding many central banks from cutting interest rates proactively. Feature Chart 1EM vs. DM Banks: More Underperformance Ahead We recommend initiating the short EM banks / long DM banks strategy. There has been a major technical breakdown in EM share prices versus DM peers (Chart 1). When discussing EM banks for the purpose of macro analysis, we separate Chinese, Korean and Taiwanese banks from their EM peers. The basis is that the banking systems in China, Korea and Taiwan1 face different cyclical and structural outlooks than in the rest of EM. Bank assets-to-GDP ratios are much more elevated and the monetary and fiscal policies have more flexibility in China, Korea and Taiwan than in EM. Chart 2Fiscal Thrust In EM And DM Reason #1: Higher NPLs In EM Than DM As a result of the pandemic lockdowns, bank NPLs have surged both in EM and DM. However, DM banks have begun to pare down the NPL provisions they had built over the past year. By contrast, NPLs in EM economies will linger due to persisting economic weakness. In fact, EM banks might need to boost their NPL provisions, further eroding their profits. DM policymakers have provided much more fiscal support to their economies than the governments in EM (ex-China, Korea and Taiwan). The fiscal thrust in these EM economies will be negative in 2021 while it is expected to be positive in the US and neutral in the euro area (Chart 2). Chart 3 shows the fiscal thrust across individual EM economies. The fiscal thrusts in Russia and Brazil are the most negative. In EM (ex-China, Korea, Taiwan), the prime lending rates have declined but are still high both in nominal terms (around 10%) and in real terms (6.5%) (Chart 4, top and middle panels). In our opinion, these levels of prime lending rates are restrictive for EM economies and will both inhibit loan demand and undermine debtors’ ability to service debt. Consistently, bank loan growth remains very muted in EM (ex-China, Korea, Taiwan) (Chart 4, bottom panel). Chart 32021 Fiscal Thrust In Individual EM Countries The pandemic is lingering in several developing countries and their vaccination efforts are trailing those of DM. Consequently, the pace and timing of a full economic recovery in EM will lag those in DM. Chart 5 illustrates that retail sales and auto purchases in EM (ex-China, Korea, Taiwan) remain lackluster. Chart 4EM Bank Lending Rates Are Restrictive Chart 5EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster   Reason #2: Net Interest Margin Squeeze For EM Banks EM banks are facing a dilemma. They have a choice between: continuing to experience rising NPLs and moribund loan demand due to restrictive lending rates, which will also undermine bank profits; and/or significantly reducing their lending rates to spur new lending and to help debtors service their loans. In such a case, their net interest margins and profits will shrink. In a nutshell, the fact that borrowers are struggling despite lending rates being much lower than they have been in the past boils down to underlying productivity and return on capital. Both have downshifted considerably in EM (ex-China, Korea, Taiwan) economies. This was true before the pandemic erupted and is also true at present. Chart 6EM Banks: Net Interest Margin And EPS In brief, the only way for EM banks to avoid escalating NPLs is to reduce lending rates. Yet, the latter will erode their net interest margins and depress their profits. Chart 6 demonstrates that net interest rate margins have been an important driver of banks’ EPS growth and they currently point to weaker bank earnings. Notably, there is little room for EM (ex-China, Korea, Taiwan) central banks to cut their policy/short rates. Doing so could trigger a weakness in their currencies at a time when US growth is booming, and US bond yields are under upward pressure. Overall, any decline in prime lending rates will produce a net interest margin squeeze for banks in EM (ex-China, Korea, Taiwan). In China, authorities have been clear that they expect banks to reduce their lending rates for SMEs even though the central bank does not plan on cutting short-term rates. Such pressure on mainland banks will intensify as growth slows in H2 2021. Hence, Chinese banks are also experiencing a net interest margin contraction. Reason #3: An Unfriendly Macro Cocktail For EM Our major global theme for 2021 is an economic boom in the US and a slowdown in China. Such a global macro dynamic warrants a rebound in the US dollar and a pullback in commodities prices. The US economy will be booming in H2 2021 facilitated by the general reopening of the economy, massive fiscal stimulus, rising employment and income growth as well as the release of pent-up demand for services. The Chinese economy is about to decelerate, as foretold by the rollover in money and credit impulses (Chart 7). China’s slowdown will lead to a decline in commodities prices and EM currencies (Chart 8). Chart 7China Is Set To Slow Down Chart 8Commodities And EM Currencies Are At Risk   Finally, one of the best leading indicators for EM EPS has been China’s narrow money growth. Chart 9 demonstrates that the latest rollover in Chinese narrow money growth heralds a slowdown in EM EPS later this year. Chart 9China's Narrow Money Heralds EM EPS Slowdown In H2 EM’s business cycle is very sensitive to China’s growth because many emerging economies sell to China as much if not more than to the US. An impending slowdown in China will cause a meaningful setback in commodities prices and will depress terms of trade for many EM (ex-China, Korea, Taiwan) economies. In turn, a booming US economy will herald higher US bond yields. Together, these dynamics will likely precipitate a rebound in the US dollar. In sum, such a macro cocktail could cause a capital exodus from EM in the coming months, depressing EM currencies and precluding many central banks from cutting interest rates proactively. As a result, EM local currency bond yields will not fall much, especially in vulnerable EM countries. Chart 10EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise Chart 10 demonstrates that the rise in EM local currency yields (shown inverted on the chart) is typically negative for EM (ex-China, Korea, Taiwan) bank stocks. This is opposite to the dynamics in the US and in Europe where bank share prices rally when bond yields rise. Reason #4: Chinese Bank Stocks Remain A Value Trap Market cap of Chinese bank stocks represents 25% of the MSCI EM bank index. Hence, the performance of Chinese bank share prices contributes significantly to the MSCI EM bank stock index. Chinese commercial banks’ assets have expanded 1.5-fold since early 2009 (Chart 11). The overwhelming part of this expansion has been driven by loan origination, purchases of corporate bonds and various claims on local governments and their affiliated vehicles.  We have written often and at length that there is no link between trends in bank assets and national or household savings. Critically, banks do not intermediate deposits into loans or savings into credit. This holds true in all countries around the world. Following such an epic credit boom in China since 2009, one would typically expect creditors in general and banks in particular to undertake a profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, Chinese banks have not yet sufficiently cleansed their balance sheets and carry a lot of non-recognized bad loans/assets. Investors doubt the quality of the banks’ books. As a result, Chinese banks’ share prices have been in limbo over the last ten years (Chart 12, top panel). Chart 11Chinese Bank Assets: An Epic Boom Chart 12Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan   Provided that this issue of mainland bank asset quality is well known, the government will not allow a full-fledged banking crisis. However, authorities will also not recapitalize banks without current shareholders experiencing losses. Overall, Chinese bank share prices might share the fate of Japanese bank stocks. The latter has been in a secular bear market even though Japan has never had an acute credit crisis (Chart 12, second panel). In a nutshell, Korean and Taiwanese bank share prices have also delivered very poor returns over the past 20 years, even though these banks have not had an acute crisis and the credit-to-GDP ratios in these economies have been rising (Chart 12, third and fourth panels). The upshot is that a rising credit penetration is not sufficient to produce value for bank shareholders. The quality of credit assets, profit margins and the starting points of both equity valuation and bank capital adequacy matter for forward returns on bank stocks. A Word On Bank Stock Valuations Chart 13EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio Even though Chinese bank stocks trade at very low multiples – the price-to-book value (PBV) ratio is presently 0.6, the latter represents a value trap. For comparison, the PBV ratio is 0.5 in Korea and 1.2 in Taiwan. Excluding China, Korea and Taiwan, the EM bank PBV ratio is well below its historical mean (Chart 13). However, this aggregate conceals the wide disparity among EM banks. Chart 14 plots banks’ return on equity (RoE) over the past 12 months on the X-axis and their PBV ratio on the Y-axis. There is a clear positive correlation between RoE and the PBV ratio.   Chart 14A Comparative Valuation Matrix For Global Bank Stocks Combining bank equity valuations and country macro fundamentals, within the EM bank space we favor banks in India, Mexico, Korea, the Czech Republic, Russia (barring a major military conflict in Ukraine) and Singapore. On the other hand, the most vulnerable are bank share prices in Brazil, Peru, Turkey, the Philippines, Malaysia and Indonesia. Concerning Chinese banks, we continue advocating the long large banks/short small and medium bank stocks strategy. The rationale is that a lot of bad news is already discounted in large bank stocks and little in listed small and medium bank stocks. In particular, the PBV ratio is 0.7 for large banks and 1.3 for small and medium banks. More so than large banks, small and medium banks are at risk from the new asset management regulation that will be implemented by the end of this year. Investment Recommendations We initiate a short EM banks / long DM banks position. This is a medium-term strategy for the next six months. This strategy is consistent with our tactical underweight in EM stocks versus DM stocks that we recommended on March 25. From a structural perspective, we continue recommending a neutral allocation to EM within a global equity portfolio. Today we are also publishing a report on India that highlights near-term downside risks to this bourse due to surging COVID-19 cases. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential super-spreader events. As a result, we recommend that asset allocators with less tolerance for volatility tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Chart 15Move Peruvian Stocks From Neutral To Underweight Finally, Peruvian bank stocks have been plunging on the heels of left-wing candidate Pedro Castillo lead in the presidential electionspolls ahead of the second round on June 6th. Chart 15 shows that surging NPLs (shown inverted) herald more downside in bank share prices. Consequently, in the context of political uncertainty, rising NPLs and a potential decline in metal prices, we are downgrading Peruvian equities from neutral to underweight. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 We refer to Taiwan (Province of China) herein in the report as Taiwan.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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 The prevalence of oligopolies and monopolies in a number of industries as well as lack of investment in hard and soft infrastructure have been the underlying cause of sluggish productivity growth in Mexico. This has weighed on per capita income growth. Mexico’s growth headwinds – manufacturing competition from China, tight fiscal and monetary policies – are now turning into tailwinds. A boom in the US economy in general and manufacturing in particular bode well for Mexico. On the domestic front, Mexico needs to adopt a more inclusive growth model. This requires dismantling monopolies/oligopolies, promoting SMEs, reducing the cost of doing business, spending considerably more on vocational training and university education, as well as reducing violence. Mexican financial markets stand to outperform other emerging markets because they are the most leveraged to booming US growth and the least exposed to China’s slowdown Investors should use a potential correction in the coming weeks/months to buy Mexican assets in absolute terms. Feature Chart 1Mexican Markets Are Facing A Technical Resistance Domestic and external factors have aligned to produce a period of economic and financial market outperformance for Mexico over the next several years. We expect Mexican equities, the peso as well as local bonds and sovereign credit to outperform their EM peers. Further, Mexican share prices in US dollar terms and the peso will eventually break above their major technical resistance lines (Chart 1). Growth Diagnostics It is tempting to blame Mexico’s economic underperformance on the election of leftist president Andrés Manuel López Obrador (or AMLO). Yet, the economy was already performing poorly long before 2019 when AMLO assumed office. Chart 2 illustrates productivity in Mexico has been stagnant since 2000. Inferior productivity growth has been the critical factor explaining Mexico’s structural growth stagnation. Lack of investment in hard and soft infrastructure is the underlying cause of sluggish productivity growth. As the top panel of Chart 3 demonstrates, capital spending in Mexico has been dwindling since 2014. Chart 2Mexico: Productivity Has Been Stagnant For The Past 20 Years... Chart 3...Due To Lack Of Investments   First, net FDI inflows into Mexico have been stagnant since the US credit crisis in 2008 (Chart 3, bottom panel). Multinational businesses have been reluctant to expand their capacity to supply US consumers. Besides, China and Vietnam have been more attractive destinations than Mexico for multinational companies. In addition, Chinese manufacturing companies’ rising share of global trade and a preference to source production in Asia rather than Mexico has played a role in lackluster FDI inflows into Mexico’s maquiladora sector. Unlike Chinese producers, Mexican manufacturers have not upgraded their competitiveness on the global manufacturing stage. In brief, there has been little “leakage” of manufacturing expertise from multinationals to local companies in Mexico.  Second, the capital spending drought has also hurt domestic industries, including service sectors. The high cost of doing business, lack of affordable financing for SMEs, and high barriers to entry have thwarted enterprise formation and innovation in Mexico, ultimately undermining productivity growth. Critically, the high cost of starting and doing business - particularly for small and medium enterprises (SMEs) - inhibits new investment, employment, and income growth. Mexican SMEs face some of the highest borrowing costs in the OECD, trailing only Brazil (Chart 4). This is due to the highly oligopolistic banking sector. Chart 4Mexican SMEs Face High Borrowing Costs… The three largest banks in Mexico control over half of all commercial banking assets. Therefore, these banks possess the pricing power to enjoy abnormally high fees and interest rate margins (Chart 5). As a result, banks earn excess profits while limiting the amount of financing, i.e., loan origination. This in turn curbs domestic demand in general and investment in particular.   Chart 5…Partially Due To Banks’ Wide Interest Rate Margins Chart 6Certain Costs Are Higher In Mexico Than In The US Another issue hindering the investment and creation of new businesses is high operating costs. Compared to the US, Mexican consumers face higher prices for electricity, gasoline and internet. Chart 6 shows gas and electricity prices in US dollars in Mexico and in the US. A big driver of this large discrepancy is the uncompetitive and state-dominated energy market in Mexico. On the whole, the prevalence of monopolies and oligopolies in several major Mexican industries has depressed capital spending. Monopolies and oligopolies are not interested in expanding their volume and rely on price hikes to secure decent profit growth and return on capital. This, along with other factors, curbs productivity growth and keeps inflation above what it would have been in a more competitive economy. Third, stagnant capital spending has been reinforced by the crash in oil prices in 2015 and ensuing fiscal tightening. Public gross fixed capital formation has plunged from 6.6% in 2008 to 3% of GDP presently. Trump’s threat in 2018 to impose tariffs on US imports from Mexico as well as the election of left-wing President AMLO have depressed business confidence and caused a major selloff in the peso. Currency depreciation led the central bank (Banxico) to hike interest rates by 525 basis points from December 2015 to July 2019. Remarkably, AMLO has pursued an even tighter fiscal policy than his predecessor. This resulted in primary fiscal surpluses during AMLO’s first two years of government. Besides, the President’s anti-neoliberal rhetoric against big businesses and foreign corporations (particularly in the oil and gas sector) has not fallen on deaf ears. Business confidence has plummeted since 2018. Bottom Line: The structural decline in capital spending in Mexico has depressed productivity growth. This structural malaise was complemented by several negative shocks such as the oil price crash of 2014-15, Trump’s threats to limit bi-lateral trade with Mexico, the collapse in investor and business confidence, extremely tight fiscal and monetary policies and most recently by the pandemic. However, all these headwinds have either already begun to abate or will reverse going forward. The Stars Are Beginning To Align Chart 7The Mexican Peso Is Cheap Exchange Rate: The Mexican peso is cheap according to its real effective exchange rate based on unit labor costs (Chart 7). The latter is the best valuation measure for any currency because it incorporates both wages and productivity, i.e., it is the proper measure of labor cost-driven competitiveness. The peso will also benefit from orthodox monetary and fiscal policies. Contrary to the consensus view, AMLO has proved be an extremely frugal president.1 He has run one of most conservative fiscal policies in the world. Finally, Mexico is presently running large trade and current account surpluses (Chart 8). Going forward, the Mexican peso will be supported by booming exports to the US, robust remittances from the US (Chart 8, bottom panel), and FDI inflows by multinational companies adding new capacity or shifting capacity from China to Mexico to service the US economy. Easing Monetary Policy: Very tight fiscal and monetary policies on the heels of negative confidence shocks have produced subdued consumer price inflation (Chart 9). Chart 8Mexico: Record Current Account Surplus Chart 9Mexico: Service Inflation Is Low   Besides, the prime lending is still reasonably high at 4.8%. Meanwhile, consumer and business credit are contracting (Chart 10). All these warrant Banxico to deliver more rate cuts. Lower lending rates will stimulate investment and consumption (Chart 11). Chart 10Mexico: Loans Are Contracting Chart 11Monetary Easing Should Boost Demand Waning Fiscal Austerity: Fiscal policy will ease relative to the past two years. The government’s targets for primary and overall fiscal balances in 2021 are 0% and -2.9% of GDP, respectively (Chart 12, top panel). In contrast with many other emerging economies, the fiscal thrust – the change in the cyclically-adjusted primary budget deficit – will only be mildly negative in Mexico in 2021 (Chart 12, bottom panel). The basis is that Mexico provided little fiscal support to the economy (only 3% of GDP) amid the pandemic in 2020 and therefore unlike many other EM economies is not facing a fiscal cliff. Critically, the nation budget’s reliance on oil revenues has diminished substantially. Oil revenues presently account for 12% of government revenues compared with 40% in 2012. Further, the public debt burden remains low at 40% of GDP. Even if one includes the debt of Pemex and all other SOEs into government debt, the ratio is still below 50% of GDP2 (Chart 13). Chart 12AMLO Has Been Very Frugal Chart 13Mexico's Public Debt Is Not A Concern Re-Configuring Global Supply Chains: Externally, Mexico has much to gain from the US’s reshoring of global manufacturing supply chains as well as fruitful trade and diplomatic relations with its northern neighbor. Mexico, and in particular its maquiladora industry,3 is very well positioned to attract a rising share of global manufacturing that plans to service North American and Latin American markets. It is an optimal candidate for reshoring operations due to its proximity and trade agreements with the US, a growing labor force and government support for the sector. Chart 14The Maquiladora Sector Is Set To Boom Maquiladora revenue comprises over 25% of national GDP. Further, the number of maquiladoras has been rising steadily in the past five years after the major shrinkage in the 2009-2015 period (Chart 14, top panel). The share of employment in the maquila sector have also been steadily rising in the past 10 years (Chart 14, bottom panel). There are a number of factors as to why maquiladora manufacturing is poised to experience another boom in the coming years and benefit from reshoring global supply chains. The geographical proximity and favorable trade agreements with the US and Canada. The newly ratified USMCA trade agreement between the US, Canada and Mexico has bi-partisan support in the US. Moreover, the election of Joe Biden will reduce the investment and trade risks from Trump’s unpredictable behavior. Biden has stated that his relationship with Mexico will be based on cooperation, not confrontation. Mexico offers competitive cost advantages over many other emerging economies. In terms of wages, Mexican manufacturing wages in US dollar terms are below those in China (Chart 15). Given that multinational companies deploy the same or similar technology and processes to all their factories worldwide, worker productivity in all plants will be the same. In nutshell, Mexico offers cheaper unit labor and shipping costs than China. Mexico has favorable demographics to support an influx of foreign factories. While the share of the working force population (ages 15 to 64) has rolled over in China and Vietnam, it is still rising in Mexico (Chart 16). Chart 15Mexican Wages Are Below Chinese Ones Chart 16Mexico Enjoys A Demographic Tailwind Booming US Demand and Manufacturing: Mexico stands to benefit from the US economic boom via higher remittances and the US industrial renaissance. The US industrial sector will experience a boom in the coming years due to fiscal stimulus in general, and infrastructure stimulus in particular, as well as industrial policies to favor national producers. This industrial boom will benefit Mexico’s maquiladora sector. Positive relations with the US have also helped Mexico in its fight against COVID-19. The US has prioritized its neighbors for the donation of surplus vaccines due to the close economic and diplomatic ties and movements of people across the border.  Mexico has thus already received 2.7 million doses of the AstraZeneca vaccine from the US, and is set to receive millions more once the US has vaccinated its entire adult population. Combined with the vaccines Mexico has already purchased and the contract to produce AstraZeneca vaccines domestically by mid-year, Mexico’s economy is poised to fully open up well before its Latin American peers. Bottom Line: Mexico’s growth headwinds – i.e. manufacturing competition from China/Asia, and tight fiscal and monetary policies – are largely turning into tailwinds. Mexico Needs More Inclusive Growth While Mexico’s cyclical outlook appears rosy, the structural picture is less certain. Authorities have progressed in their tax evasion and banking concentration reforms, but such efforts against oligopoly powers and violence remain insufficient. Oligopolies Oligopolies dominate a number of industries in Mexico including telecom, banks, oil and gas, electricity, bread and flour, alcoholic beverages, and entertainment, to list just a few. Oligopolies have adverse effects on the real economy.  Incumbent companies have pricing power and can extract excessive rents using their market dominance. Ceteris paribus, inflation is higher in economies where monopolies and oligopolies are prevalent than in economies with more competitive industry structures. In turn, elevated inflation keeps interest rates higher than what economic agents other than oligopolies and monopolies can handle. Another outcome of an oligopolistic and monopolistic industry structure is lopsided income distribution. Because of the prevalence of oligopolies and monopolies in domestic industries, Mexico’s national income has historically been skewed toward corporate profits at the expense of labor income. Chart 17Labor Is In A Much Better Position in The US Than In Mexico The top panel of Chart 17 reveals that operating profits of enterprises make 64% of national income while wages and salaries amount to 30%. By comparison, in the US where the share of company profits has risen at the expense of labor in the past several decades, the former stands at 25% and the latter at 54% of national income (Chart 17, bottom panel). In brief, Mexican corporates’ earning power supersedes that of employees and the outcome is considerable income inequality. Further, cash-rich incumbent companies use their powers to preclude the entry of new competitors. Consequently, the supply side of the economy lags, with negative ramifications for productivity, efficiency, and potential growth. AMLO’s stance against oligopolies has been mixed. On the one hand, he has advocated for higher taxes for large domestic and international corporations – as a way to reduce their excess profits – and has advocated for more competition in the private industry. On the other hand, he has doubled down on state-owned enterprises in the oil and gas and electricity sector. In the private sector, AMLO has been cracking down on tax evasion by large corporations. While this has been seen as excessively harsh by the business community, it has yielded positive results in terms of tax collection: income tax has increased by 2.4% of GDP due to this initiative. This figure underestimates the progress achieved given that recessions tend to weigh down on tax collection as a share of GDP. Moreover, the central bank and the government are aligned in the need to expand the accessibility of the banking system and introduce competition to lower sky-high banking rates and fees (Chart 5 above). In particular, Banxico introduced a free-to-use mobile app for financial transactions between customers and business owners that does not charge any fees. This will force downward pressure on bank transaction fees. While AMLO is positioning himself as a guardian of small businesses, SMEs’ sentiment towards the government is mixed. The only financial support SMEs have received from the government during the pandemic lockdowns was a one-time loan of 25 thousand pesos (equivalent at the time to just one thousand US dollars). Further, there was a 10% net drop in the number of SME companies last year. On a positive note, the government has announced plans this year to drastically reduce bureaucracy in the process of starting and getting permits for new businesses, as well as to simplify the tax regime for SMEs. Knowledge Economy Mexico has seen little improvement in educational standards, which is essential for the advancement toward a knowledge-based economy. The shares of students enrolled in tertiary education and vocational training have been stagnant (Chart 18, top and middle panels). Government spending on education has plummeted as a share of GDP (Chart 18, bottom panel). A substantial increase in the number of enrolled students and an improvement in the quality of vocational training and university education are necessary for long-run productivity gains. Chart 18Mexico Needs To Ramp Up Investment In Education Chart 19Violence Remains High In Mexico Violence The other electoral mandate for AMLO was to tackle rising violence by drug cartels. Homicides have remained flat in the last two years. Yet, the level of violence is so high that just a maintenance of previous years’ levels is not acceptable to the population (Chart 19). Hence, AMLO has yet to fulfill his election promise to reduce violence. In all fairness, AMLO’s signature policy to fight crime and gang violence was put on pause due to Trump’s insistence on curbing Central American migrants via Mexico to the US. The government was forced in 2019 to relocate and repurpose the newly created National Guard to stem immigration flows at the south of the border as President Trump threatened Mexico with tariffs. With no such pressure from the Biden administration, the National Guard will be deployed for its original purpose, we feel the need to give AMLO the benefit of the doubt on this issue for the next 12 months.  Bottom line: Mexico needs to boost productivity and adopt a more inclusive growth model. This requires curbing and dismantling monopolies/oligopolies, promoting micro-enterprises and SMEs, reducing the cost of doing business, considerably increasing both the number of students enrolled in and the quality of vocational training and university education as well as reducing violence. All of these changes, if implemented, will not only boost aggregate national income but will also lead to a more equitable income distribution. As the share of income allocated to wages and small entrepreneurs rises, so will household spending. Investment Recommendations Our major global economic theme for next six-to-nine months is a booming US economy amid a Chinese economic slowdown. Consequently, Mexico and its financial markets stand to benefit and outperform their EM peers, as its economy is the most leveraged to US growth and the least exposed to China among EM economies. On another matter, as Mexico’s political stability and economic outlook is contrasted with other Latin American countries (particularly Brazil), regional investors will reallocate funds into Mexican financial markets. Investors should use a potential correction in the coming weeks or months to buy Mexican assets in absolute terms too. Equities: The underperformance of Mexican stocks versus the EM equity index is very late. We were too early in overweighting this bourse but reiterate our overweight stance. Mexican equities will benefit from monetary easing, improving domestic demand and reasonable valuations (Chart 20). Mexican local bond yields have dropped relative to EM aggregate bond yields heralding Mexican equity outperformance versus its EM peers (Chart 21). Chart 20Mexican Equities Are Attractively Valued Chart 21Mexican Stocks Will Outperform The EM Benchmark Besides, the Mexican bourse has no exposure to TMT stocks. If TMT stocks underperform as we expect, the Mexican stock market will outshine the EM benchmark that is heavy in TMT stocks. The Exchange Rate: The Mexican peso is cheap (Chart 7 above), and investors should favor the peso among EM currencies. Fixed-Income Markets: Orthodox fiscal and monetary policies as well as the public debt profile prompt us to continue recommending an overweight allocation to Mexico in both local currency bonds and sovereign credit portfolios. We also recommend investors continue receiving 10-year swap rates in Mexico. For credit investors, we reiterate short Mexican CDS / long Brazilian and South African CDS.   Juan Egaña Research Analyst juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1We have argued since June 28th 2018 that AMLO will not be a fiscally irresponsible president. 2We discussed this topic in detail in our past report. 3Maquiladoras are foreign-owned manufacturers operating in Mexico, mostly in municipalities along the northern border. They are distinct from other businesses in the country as they are specifically set up to export manufacturing goods. In return they do not pay duties on imported materials and equipment and face lower tax rates as well as subsidies for workers’ benefits.

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