Financial Markets

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

The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Investors’ hunt for yield over the past few years led them to view leveraged loans as an attractive investment. Characterized by low volatility and attractive risk-adjusted returns, leveraged loans can add value to a portfolio. Leveraged loans tend to outperform their fixed-rate counterparts (for example, high-yield bonds) in an environment of rising rates and an attractive valuation starting point. Only the former criterion is true currently. Risks do exist, however. The increasing share of covenant-lite issues, and rising leverage in the corporate sector are of particular concern. Over the next 6-to-12 months, we do not expect rates to rise substantially, making the asset class somewhat unappealing in the short term. The longer-term outlook is attractive nevertheless, since rates are likely to rise as inflation picks up over the coming years. Feature In today’s environment of ultra-accommodative monetary policy, including low interest rates, and unattractive valuations for fixed-income risk assets, investors have no option but to look beyond conventional fixed-income instruments and dial up their risk appetite. In this Special Report, we run through the mechanics of the leveraged loan market. We analyze historical risk-return characteristics and compare leveraged loans to other assets. We also assess their performance during periods of financial-market stress as well as periods of rising rates and inflation. Finally, we discuss the risks associated with owning leveraged loans. What Are Leveraged Loans? Leveraged loans are a type of syndicated loan made to sub-investment-grade companies. Generally, these firms are highly indebted, with low credit ratings. A syndicated loan is structured, arranged, and administered by one or several commercial or investment banks.1 The majority of these loans are senior secured loans and are based on a floating rate, mostly LIBOR plus a premium (more than 150-200 bps) to account for their riskiness as well as to attract non-bank institutional investors. The interest rates on these loans adjust at regular intervals to reflect changes in short-term interest rates; this constitutes a benefit for investors worried about rising rates. Definitions vary when it comes to categorizing leveraged loans. Some group them based on the borrower’s riskiness and their credit rating. Others consider leverage metrics such as debt-to-capital and debt-to-EBITDA. Other classifications look at the spread at issuance or the purpose of the fund raising, which can include funding mergers and acquisitions (M&A), leveraged buyouts (LBOs), refinancing existing debt, or general funding. Over the past five years, approximately 50% of US leveraged loans issued were for refinancing purposes (Chart 1, panel 1). Within the three categories, LBO financing is deemed the riskiest, and this is reflected in its higher spread (Chart 1, panel 2). The leveraged-loan market became particularly popular in the mid-1980s as M&A activity was soaring (Chart 2). Chart 1Uses Of Leveraged Loans Chart 2The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth There are two common types of financing facilities:2 Term loans: An agreement to borrow a sum of money that is paid back over a certain payment schedule. These loans are mainly provided by non-bank entities. Revolving facilities: A type of loan that can be repeatedly drawn upon and repaid. These loans are mostly originated and held by banks. Estimates for the size of the leveraged-loan market vary depending on which criteria and definitions are used. The size of the leveraged-loan market, following rapid growth since the beginning of the past decade, is estimated to be over $1.2 trillion as of Q2 2020.3 While this represents only a small portion of overall corporate debt (it is only 15% the size of the corporate bond market), the interconnections between key market participants and the role of banks in the market has caught the attention of several regulators such as US Treasury Secretary Janet Yellen, debt investors such as Howard Marks, and international institutions such as the Bank For International Settlements (BIS). The focus of their concerns has been on the declining credit standards for leveraged loans – particularly, the increase in issuance of “covenant-lite” (cov-lite) loans, inconsistent definitions of EBITDA in loan agreements, the growth in use of “EBITDA add backs”,4 and the accuracy of leveraged-loan ratings.5 We discuss some of those concerns in the Risks section. Table 1Risky Loans Are Mainly Held By Non-Bank Entities… Over the past several decades, the role of banks in providing capital to the leveraged loan market has shrunk and has been replaced by non-bank lenders such as mutual funds, hedge funds, insurance companies, and asset managers.6 Data by the Shared National Credit (SNC) program7 shows that non-bank entities in the US now hold close to 83% of all non-investment-grade term loans (Table 1). Moreover, estimates by the Bank of England8 (BoE) show that a quarter of the global stock of leveraged loans (which it estimates at close to $3.4 trillion) is held through collateralized loan obligations (CLOs)9 and approximately half is owned by non-bank institutions. In turn, those non-bank institutions hold a significant portion of CLOs – particularly the riskier tranches. This is not to say that banks are not exposed to leveraged loans. But banks predominantly invest in the highest, AAA, tranche of CLOs, and investment-grade loans.10 Riskier-rated loans are held by CLOs, mutual funds, and other lenders such as hedge funds (Chart 3).11 Chart 3…Particularly Those Rated Below BB Historical Risk And Return Chart 4Leveraged Loans' Relative Performance Moves With Interest Rates Since 1997, leveraged loans12 have returned an annualized 4.9%, 25 basis points higher than US Treasurys and approximately 100 and 200 basis points less than US investment-grade and high-yield bonds, respectively. They have underperformed US equities by an annualized 400 basis points over the same period. Declining rates over the past two decades are the most likely reason leveraged loans have underperformed their fixed-rate counterparts. The relative performance of leveraged loans to investment-grade bonds has closely tracked the trajectory of Treasury yields (Chart 4). While the case is not as clear for relative performance against high-yield bonds, the trend is similar. However, on a risk-adjusted return basis, due to reduced volatility, leveraged loans did outperform both equities and high-yield corporate bonds (Table 2). We nevertheless think that volatility is likely understated given the elevated kurtosis. The larger negative skew and excess kurtosis could indicate higher probabilities of large negative returns (Chart 5).   Table 2Historical Risk-Return Characteristics Chart 5Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Why Should Investors Consider Leveraged Loans? Chart 6Rising Rates Support Higher Return From Leveraged Loans... Our US bond strategists have showed that the odds of leveraged loans outperforming fixed-rate high-yield bonds increase when certain criteria are in place – particularly when valuations are tilted in loans’ favor, and Treasury yields are rising.13 Only the latter criterion is true currently. Year-to-date, leveraged loans have returned 2.2%, higher than the -3.2%, -3.4%, 1.6%, and -3.4% from US Treasurys, investment-grade bonds, high-yield bonds, and emerging markets sovereign debt, respectively (Chart 6). During the same period, Treasury yields rose by 65 basis points. We find that periods of rising Treasury yields are associated with increased flows into the asset class (Chart 7). More interestingly, leveraged loans outperform junk bonds when Treasury yields rise faster than what is discounted in the forwards curve over the following 12 months (Chart 8). Chart 7...As Well As Increased Fund Flows Chart 8Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve     This does not seem to be the case today, however, with the 5-year, 1-year forward about 40 basis points higher than the current 5-year Treasury yield. This is in line with our view that rates are unlikely to rise substantially over the next 6-to-12 months. Inflation, beyond a temporary spike over the next few months, should remain subdued, at least until employment is back to a level which would put upward pressure on wages. This is unlikely before 2023. It is also important to consider the potential trajectory of monetary policy as well as changes in long-term yields. The Fed, through its dot plot, is signaling no increase in the Fed Funds Rate before 2024, but the market is becoming worried about inflationary pressures and pricing in an earlier Fed hike. We believe it unlikely that the Fed will raise rates ahead of what the market expects, unless the labor market returns to “maximum employment” over the next 12 months. The yield on leveraged loans has been lower than on high-yield bonds for most of the period we have data for, except early 2020. Given leveraged loans’ senior position in a firm’s capital structure, it makes sense that their yields are lower. Additionally, the sector composition of the two markets plays a role: Leveraged loans are more exposed to the Technology and Communications sectors and have a limited allocation (averaging 1% over the past seven years) to the Energy sector, unlike high-yield, fixed-rate bonds (where the weight of Energy has averaged 13%) (Chart 9). This was mostly evident when the yield differential collapsed to below -3% during the 2014/2015 oil crash (Chart 10). Chart 9Leveraged Loans’ Sector Weightings Chart 10Loan Spreads Are Not Looking Attractive Chart 11Recent Investor Demand Pushed Up Leveraged Loan Prices The yield differential has, however, been trending upwards since then, and at current prices, upside may be limited. The recent surge in investor demand has pushed down yields on newly issued leveraged loans, moving the average bid price of leveraged loans above its pre-pandemic high (Chart 11). In the next section, we analyze how leveraged loans have behaved during recessions and other periods of financial market stress.   Financial Market Stress Performance In Crises Given the index’s short history, we are able to cover only the past three recessions (the dot-com bubble bust, the Global Financial Crisis (GFC), and the COVID-19 recession). We also look at the 2013 Taper Tantrum and the 2014/2015 oil price shock. In all cases, leveraged loans fell and subsequently recovered along with other fixed-income asset classes. The Taper Tantrum was the most favorable for leveraged loans: 10-year Treasury yields rose by 100 basis points over four months (Chart 12). Table 3 shows that periods of rising rates are a better environment for leveraged loans than those of declining rates. We also looked at a period of Fed tightening and easing cycles – although the timing of easing cycles overlaps with, recessions, dragging down the performance of leveraged loans. We also assess the impact of inflation on leveraged loans using the framework from our Special Report on inflation hedging,14 which decomposed inflation into four quartiles/regimes: Inflation levels below 2.3%, between 2.3% and 3.3%, between 3.3% and 4.9%, and above 4.9%. We add periods of decreasing inflation to our analysis. We note, however, that there was only one period where inflation was over the 4.9% threshold. Chart 12Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress   Table 3Leveraged Loans’ Performance During Different Rate Cycles… Table 4…And Inflation Regimes During periods in the first and second inflation quartiles, leveraged loans, in absolute terms, had the highest average annualized returns, 8.1% and 10% respectively. This makes sense since in those regimes, policy rates are low and bond yields begin to rise given robust growth. Leveraged loans, however, underperformed fixed-rate bonds during those periods. Inflation above 3.3% represents an environment in which the economy begins to overheat and growth to falter. This regime saw leveraged loans outperform high-yield bonds by an annualized 1.5%. Periods of declining inflation also showed moderately positive annualized returns for leveraged loans (Table 4).   Risks Chart 13Corporate Health Has Worsened... The growth of the leveraged loans market reflects multiple trends but, most importantly, a broad increase in corporate leverage, driven by a decline in interest rates and increasing availability of cheap financing. The debt-to-asset ratio of nonfinancial businesses, a gauge of corporate leverage, is at a 20-year high (Chart 13, panel 1). This raises concerns about the overall health of the corporate sector – particularly firms’ ability to service their debt – since the median interest coverage ratio is near a level last seen during the GFC. This measure is even negative for companies within the 25th percentile, meaning companies in that bucket lack funds to maintain their interest payments (Chart 13, panel 2). Trends in the leveraged loan market paint a similar picture. The share of newly issued loans by the most highly levered firms – those with a debt-to-EBITDA ratio of 6x or higher – has reached new highs, hitting 37% of new loans in Q3 2020 (Chart 14). Chart 14…Even For Leveraged Lending Chart 15Cov-Lite Issuances Make Up Almost 80% Of New Issuances The providers of capital are partly to blame. Even with credit standards deteriorating, firms looking for capital were mostly able to find it. The share of cov-lite structures – loans that lack the protective covenants found in traditional loans – continues to grow and now comprises almost 80% of new issuance (Chart 15). Cov-lite loans typically do not have any maintenance covenants, requirements to maintain certain ratios such as leverage or interest-coverage ratios.15 Instead, they feature incurrence covenants which have to be met only if the issuer wants to take particular actions, such as taking on more debt.16 This loosening of credit terms is mostly a function of increased demand, particularly by CLO buyers and other non-bank institutional investors, in an environment of low yields. Some have even warned that vulnerabilities in the leveraged-loan market could cause disturbance to the overall financial system. Particularly, memories of the GFC and worries about the “originate-to-distribute” model – whereby banks originate loans but retain only a fraction on their balance sheets – have led some observers to suggest this could all lead to a risky expansion of credit, and trigger a new financial crisis. Chart 16Leveraged Loans Have Higher Average Credit Ratings… We do not share this skepticism. Banks’ exposure to leveraged loans is mainly via the highest tranches of CLOs. Banks’ liquidity requirements have increased since the GFC, and therefore contagion should be minimal in the event of problems in the loan market. A recent report by the US Government Accountability Office (GAO) did not find evidence that leveraged lending presented a significant threat to financial stability.17 Additionally, almost all leveraged loans are first lien, they have a senior secured position in the capital structure, higher average credit ratings than high-yield bonds (Chart 16), and lower default rates (Chart 17). Moreover, their five-year average recovery rate of 63% tops the 40% of senior unsecured bonds (Chart 18). Chart 17...Lower Default Rates... Chart 18...And Higher Recovery Rates Than High-Yield Bonds   Conclusion In a period of ultra-low interest rates and stretched valuations for risk assets, leveraged loans have emerged as an interesting asset class for investors. Due to lower volatility, leveraged loans have historically produced higher risk-adjusted returns than fixed-rate high-yield bonds. However, volatility is likely understated given elevated levels of kurtosis. Historically, rising Treasury yields and an attractive valuation starting-point provided a signal for leveraged loans’ outperformance. Only one of those two criteria are currently in place. In the next 6-to-12 months, we do not believe rates will rise substantially, making this asset class somewhat unattractive in the short term. The longer-run outlook for leveraged loans, however, is attractive. As inflation, and therefore rates, rise over the next two-to-three years, a moderate allocation to leveraged loans might be a useful hedge for investors.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1 Please see “LCD Loan Primer – Syndicated Loans: The Market and the Mechanics,” S&P Global Market Intelligence. 2 Please see “Leverage Lending FAQ & Fact Sheet,” SIFMA, February 2019. 3 Please see “Federal Reserve Financial Stability Report,” November 2020. 4 “EBITDA add backs” add back expenses and cost savings to earnings and could inflate the projected capacity of the borrowers to repay their loans. 5 Please see Todd Vermilyea, “Perspectives On Leveraged Lending,” The Loan Syndications and Trading Association 23rd Annual Conference, New York, October 24, 2018. 6 Please see “Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle, Chapter 1,” IMF, April 2019. 7 The SNC Program is an interagency program designed to review and assess risk in the largest and most complex credits shared by multiple financial institutions. The SNC Program is governed by an interagency agreement among the three federal bank regulatory agencies - the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office Of the Comptroller Of The Currency (OCC). 8 Please see “Financial Stability Report,” Bank of England, August 2020. 9 CLOs are asset-backed securities issued by a special purpose vehicle which acquire a portfolio of leveraged loans. 10 Please see “Turns Out Leveraged Loans Aren’t a Systemic Risk After All,” Bank Policy Institute, February 8, 2020. 11 Please see Seung Jung Lee, Dan Li, Ralf R. Meisenzahl, and Martin J. Sicilian, “The U.S. Syndicated Term Loan Market: Who holds what and when?”, November 25, 2019. 12 For the purpose of this report, we use the S&P/LSTA Leveraged Loan Index, which tracks the market-weighted performance of US dollar-denominated institutional leveraged loan portfolios. 13 Please see US Bond Strategy Report, “The Price Of Safety,” dated January 27, 2015. 14 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 15 Please see Eric Goodison And Margot Wagner, Paul, Weiss, Rifkind, Wharton & Garrison Llp, “Covenant-Lite Loans: Overview,” August 2019. 16 Please see Scott Essexx, Alexander Ott, Partners Group, “The Current State Of The Leveraged Loan Market: Are There Echoes Of The 2008 Subprime Market?”, March 2019. 17 Please see “Financial Stability: Agencies Have Not Found Leveraged Lending To Significantly Threaten Stability But Remain Cautious Amid Pandemic,” United States Government Accountability Office, December 2020.

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

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

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

Highlights Biden will host a global summit for Earth Day on April 22-23, giving public attention to his climate change policy push. Investors should count on Biden’s green infrastructure package becoming the bulk of his climate push, given uncertainty over the 2022 midterm elections. However, over the long run, American public opinion is shifting in favor of renewables and the US will seek to maintain its technological edge via participating in the green tech race. Go long our “Biden Fiscal Advantage Basket” versus the Nasdaq 100.  Feature The Biden administration’s $2.3 trillion American Jobs Plan is often referred to as a “green infrastructure” package and in this report we take a look at what makes it green – and what are the investment implications. Biden will virtually host a global climate summit on April 22-23, Earth Day, which the Chinese President Xi Jinping is expected to attend, thus providing momentum to the green investment theme. The stock market anticipated Biden’s electoral victory last year and renewable energy stocks rallied exorbitantly, with ultra-easy monetary and fiscal policy as a fundamental support. The market’s reaction to Biden’s official outline of his plan last month suggests that investors are energized about Biden’s infrastructure package but already suffering from some green fatigue (Chart 1). However, this bill’s passage will initiate the US’s official entrance into the global green energy race and from that point of view renewable plays should recover. Once the American Jobs Plan passes, likely sometime this fall, Biden’s climate agenda will be virtually finished, from an investment perspective. Investors have little visibility beyond 2022 as the president’s party rarely hangs onto the House of Representatives in his first midterm election. However, over the long run, American public opinion is shifting in favor of renewable energy. And Biden also has regulatory tools to push the Democratic Party’s climate agenda from 2022-24 regardless. Chart 1Biden's AJP Already Priced Chart 2Biden’s First Budget: Boom In Non-Defense Discretionary Spending Biden’s first presidential budget, released on April 13, also highlights the US’s attempt to boost climate policy (the Environmental Protection Agency’s funding would go up by 21%). More broadly it highlights the US’s ongoing sea change in fiscal policy. Discretionary spending turned around under President Trump’s populism and will continue under Biden’s populism. The difference lies in social spending versus defense. Biden proposes a 15.2% increase in non-defense discretionary spending, with education, commerce, health, and environment while the departments of defense and justice see much smaller increases (Chart 2). But we doubt that even defense spending will be curtailed given the US’s global strategic challenges. The president’s budget proposals are drops in the bucket compared to the trillions in his economic stimulus packages. Biden’s American Family Plan will be outlined in detail later this month but it only has a 50/50 chance of passing by the 2022 midterm election. This leaves us with the American Jobs Plan as the real macro policy factor to watch. And in the case of green energy, in particular, the Democrats may not have another opportunity to pass major legislation for many years. The US’s Strategic Basis For Green Energy The American Jobs Plan is billed as a $2.3 trillion green infrastructure package but in reality the package should be broken into traditional infrastructure ($784 billion for roads and bridges), social welfare ($647 billion  for elderly care, education, etc), green initiatives ($370 billion for electrical grid and retrofits, etc), tech initiatives ($280 billion for broadband, semiconductors, research and development), and small business support, in order of dollar value (Chart 3). The implication is that climate policy is important but not the top priority. Still, $370 billion is the biggest green package the US has ever launched. It consists of $150 billion for “hard” green infrastructure, such as new electricity grid and $220 billion for “soft” green infrastructure, such as tax credits for buying EVs (Chart 4). Chart 3Biden’s AJP: Green Initiatives Total $370 Billion Chart 4Biden’s AJP: Green Initiatives Mostly Rebates/Incentive The US has moved slowly on green energy policy – relative to Europe or China – because it does not face the same strategic necessity. China faces domestic social unrest if it does not reduce pollution, it faces American strategic containment if it does not reduce its dependency on the Middle East (35% of total oil consumption), and it faces the middle-income trap if it does not increase innovation and productivity. Europe is similarly dependent on a geopolitical enemy for its energy supply – Russia provides 35% of its oil consumption and 38% of its natural gas – and it must also increase productivity. Europe and China are net energy importers who have a great strategic interest in making energy supply a matter of manufacturing prowess rather than divine natural resource endowment (Chart 5). The US is late to the green energy game in part because it does not share the same degree of strategic necessity. Like the EU, the US took care of its most pressing pollution problems decades ago. But unlike the EU, the US is a net energy exporter thanks to the fracking revolution. However, the US is not truly energy independent – an Iranian closure of the Strait of Hormuz would cause global oil prices to spike and trigger a recession. And the US also has a powerful strategic interest in maintaining its global leadership and its edge in technology, innovation, and productivity (Chart 6). The US cannot afford to miss out on the green tech race even if starting from a more secure natural resource base. Chart 5US Green Focus Less Motivated By Energy Security Than China, EU US public opinion is also following European opinion regarding climate change and environmental protection. True, voters are more urgently concerned about the economy, jobs, and health care over the environment – as we showed in our Special Report on health care earlier this year. But the administration has decided not to rehash the health care battles of the Obama administration – having seen Republicans fail to repeal Obamacare – and instead to open up a new policy domain with climate change. Even if the environment is low priority for most voters, they do not oppose green projects in principle – in fact, they favor renewable energy over fossil fuels when it comes to the US’s energy future (Chart 7). And voters strongly favor infrastructure, which means they are more susceptible to green energy projects when presented as part of a broader infrastructure buildout – as opposed to a transformative “Green New Deal” designed to revolutionize every aspect of US life. Chart 6US Green Focus Motivated By Global Innovation/Tech Race Chart 7US Public Supports Renewable Energy The US shift to green energy is well underway, with renewables ready to surpass coal in the national energy mix (Chart 8). The natural gas boom of the past decade has worked wonders in reducing coal dependency and hence overall carbon emissions (Chart 9). Chart 8Shift To Renewables Well Underway Chart 9US Carbon Emissions To Fall Further Bottom Line: The US does not have the same energy security problems as China and the EU, which is one reason the US trails these competitors in green energy production and policy. But the US has a powerful interest in maintaining its technological edge and productivity growth. So policymakers will continue to push the green agenda even as the public follows Europe in becoming more favorable toward it over the long run. US Climate Policy Will Advance In Fits And Starts The fact that the US lacks the same strategic urgency as Europe and China suggests that the green energy push in the US will progress in fits and starts rather than in a straight line. Popular opinion cited above is supportive enough to allow a political party to push a green agenda if it has control of both the White House and Congress. The Biden administration has moderate-to-strong political capital based on our Political Capital Index (Appendix). But this could change with the next election, which would introduce a ruffle in the current narrative in which Biden saves planet earth. One factor that helps Biden is that his presidency is entirely about economic stimulus and recovery, which enables him to minimize the regulatory and punitive side of his party’s energy agenda. While the American Jobs Plan includes corporate tax hikes, his climate policy in itself is all about spending rather than taxation. There is no carbon pricing scheme anywhere to be seen. And Biden’s Transportation Secretary, Pete Buttigieg (“Mayor Pete,” a center-left politician from Indiana), immediately reversed his recent suggestion that the government levy a gasoline tax or vehicle mileage tax. Biden cannot get any revolutionary green measures passed through the Senate, given that moderate Democrats like Senators Joe Manchin of West Virginia and John Tester of Montana hail from coal-heavy states. The Democrats must also pay heed to the swing states for future elections. Biden only narrowly won his home state of Pennsylvania, after pledging to phase out oil and natural gas in the last presidential debate. True, Biden’s American Jobs Plan will remove subsidies for the oil and gas sector – but these subsidies are not very large. Notably, subsidies for renewables already overwhelm those for traditional infrastructure, even under the Trump administration (Chart 10). Chart 10Subsidy Reform Will Promote Renewables Chart 11Green Policy At Risk In 2022 Midterm These points underscore the fact that US climate policy is uncertain over the medium term, when the pandemic fades and the Democrats attempt more ambitious climate proposals. The Republican Party supports the traditional energy sector and is skeptical about climate change. The GOP could easily make a net gain of five seats in the 2022 midterm elections and take back control of the House of Representatives. They would not be able to repeal Biden’s laws or regulations, given his veto and likely Democratic majority in the Senate, but they would be able to pare back green funding. Republicans are not uniform on the issue of climate but more than half of Trump supporters in 2020 considered climate change unimportant. Young party members, moderates, and women were more split on the issue, with 60% of moderate Republicans viewing climate change as somewhat or very important (Chart 11). The takeaway is that Republicans would obstruct but not repeal future climate policy. Climate policy would be limited to Biden’s regulations until at least 2024. Hence investors can expect US climate policy to plow forward in the short run but to encounter resistance in the medium run. This is also likely to be the case as various other crises will emerge and soak up government attention and resources (most likely geopolitical conflicts). Chart 12Green Policy More Likely Over Long Term Over the long run climate policy will have more reliable support. Younger Republicans support federal environmental policy more than their elders, are increasingly favorable toward government regulation to that end, and prefer renewables to fossil fuels (Chart 12). The millennials and younger generations will make up more than half of the electorate by around 2028. Even then the government’s focus on climate will wax and wane given the other pressing matters of the day. Investment Takeaways A tsunami of money has been created, a lot of it is finding its way into the stock market, and a lot of it is finding its way into green and sustainable energy companies – companies that now have a privileged position in terms of both government support and conspicuous consumption. Combine this with a tidal wave of institutional funds pouring into anything and everything labeled ESG (environmental, social, and governance) – and the stigma attached to climate skepticism and denialism – and investors should fully expect irrational exuberance and stock bubbles. Consider the US’s premier EV maker, Tesla. The vertical run-up in Tesla stock has occurred alongside the run-up in US money supply. Tesla’s price trend conforms with the profile of a range of stock market bubbles of the past (Chart 13), as shown by our US Equity Strategy. Chart 13ALow Rates And Vast Money Growth... Chart 13B...Will Fuel Green Bubble That being said, renewables stocks surged throughout 2020 on the back of stimulus and Biden’s likely election – and have since fallen back. They have underperformed cyclical and defensive sectors alike this year to date (Chart 14). As highlighted above, the Democrats’ climate ambitions could yet be pared back in the Senate. However, given the argument in this report, there is sufficient political capital for the climate provisions of the American Jobs Plan to pass. Renewable plays should recover, at least on a tactical, “buy the rumor, sell the news” basis. To play Biden’s American Jobs Plan, our US Equity Strategist Anastasios Avgeriou constructed a “Biden Fiscal Advantage Basket” comprising eight ETFs and one stock, all equal weighted (Chart 15, top panel). Instead of buying specific stocks, Anastasios opted for ETFs so as to diversify away company-specific risk. Chart 14Renewables Corrected But Will Recover Chart 15Introducing The Biden Fiscal Advantage Basket The goal was to filter for ETFs that hold mostly US companies and that offered the highest possible liquidity. From a portfolio construction perspective, he aimed to match the different spending segments of Biden’s White House proposal with an ETF. The ticker symbols included in the basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. Granted there is some replication of stocks included in these ETFs. In certain ETFs there is also a sizable international stock exposure, including EM and Chinese stocks. One final caveat is that these ETFs have a high concentration of technology stocks. Our sense is that this basket should outperform the S&P500 on a cyclical and structural basis albeit not tactically (Chart 15, middle panel). However, given the high-tech exposure, our preferred way to express this trade is via a long/short pair trade versus the QQQ high-tech ETF, which tracks the largest 100 companies on the Nasdaq stock exchange (Chart 15, bottom panel). Table 1 shows a number of related ETFs that did not make the cut but that readers may find intriguing and that deserve further research. Later this month we will publish a joint special report with our US Equity Strategy service, updating our views on Biden’s proposals and elaborating on this equity basket. Table 1Infrastructure and Renewables Related ETFs More broadly, US equities are still enjoying a positive cyclical backdrop, whereas the passage of the American Jobs Plan later this year has a 50% chance of marking peak stimulus (the American Families Plan may not pass). Tactically, however, we are more cautious. There are also several pronounced foreign policy stress tests facing the Biden administration imminently, including serious Russia/Ukraine, Israel/Iran, and China/Taiwan saber-rattling that we fully expect to engender volatility and safe-haven flows. At least one FOMC member, Saint Louis Fed President Jim Bullard, is now openly thinking about thinking about the Fed’s tapering asset purchases – that is, once the US vaccination rate reaches 75%. Our US Investment Strategy recently showed that this rate of vaccination could be reached as early as September.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1Political Risk Matrix Table A2Political Capital Index Table A3APolitical Capital: White House And Congress Table A3BPolitical Capital: Household And Business Sentiment Table A3CPolitical Capital: The Economy And Markets Table A4Biden’s Cabinet Position Appointments

Highlights Duration: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. Employment: The US employment boom is just getting started. Total employment is still 8.4 million below pre-pandemic levels, but 37% of missing jobs are from the Leisure & Hospitality sector where demand is about to surge. Fed: The US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Feature Chart 1Price Pressures Building The past two weeks brought us a couple of interesting developments directly related to the Treasury market. First, long-dated Treasury yields declined somewhat, presumably because many investors concluded that the yield curve is already priced for the full extent of future Fed rate hikes. Second, we received further evidence – from March’s +916k employment report, the 12% year-over-year increase in producer prices and continued elevated readings from PMI Prices Paid indexes – that economic activity is recovering more quickly than even the most optimistic forecasters anticipated (Chart 1). These two opposing forces highlight a tension in the current outlook for US Treasury yields. Yields now look fairly valued on several different valuation metrics, a fact that justifies keeping bond portfolio duration close to benchmark. However, cyclical economic indicators are surging, a fact that suggests yields will keep rising in the near-term, causing them to overshoot fair value for a time. This week’s report looks at this tension between valuation indicators and cyclical economic indicators through the lens of our Checklist To Increase Portfolio Duration. While we think there are convincing arguments in favor of both “At Benchmark” and “Below Benchmark” portfolio duration stances on a 6-12 month investment horizon, we are deciding to stick with our recommended “Below Benchmark” stance for now, until the economic data are more in line with market expectations. Checking In With Our Checklist Back in February, following the big jump in bond yields, we unveiled a Checklist of several criteria that would cause us to increase our recommended portfolio duration stance from “Below Benchmark” to “At Benchmark”.1 As is shown in Table 1, the Checklist contains seven items that can be grouped into two categories: Valuation Indicators that compare the level of Treasury yields to some estimate of fair value Cyclical Indicators that look at whether trends in the economic data are consistent with rising or falling bond yields Table 1Checklist For Increasing Duration Valuation Indicators Chart 2Valuation Indicators As mentioned above, valuation indicators show that Treasury yields are roughly consistent with fair value, suggesting that a neutral duration stance is appropriate. First, consider the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate (Chart 2). Last week, survey estimates from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers were updated to March, and while there was some upward movement in the estimated long-run neutral rate ranges, the median estimates in both surveys were unchanged from January. The result is that the 5-year/5-year forward Treasury yield remains near the top-end of its survey-derived fair value band (Chart 2, top 2 panels). Second, the same two surveys also ask respondents to forecast what the average fed funds rate will be over the next 10 years. We can derive an estimate of the 10-year term premium by subtracting those forecasts from the 10-year spot Treasury yield (Chart 2, bottom 2 panels). In this case, respondents did raise their average fed funds rate forecasts and our term premium estimates were revised down as a result. While both term premium estimates are now below their 2018 peaks, they remain elevated compared to recent historical averages. Third, we turn to the front-end of the yield curve to look at what sort of Fed rate hike path is priced into the market (Chart 3). We see that the market is currently priced for Fed liftoff in December 2022 and for a total of four 25 basis point rate hikes by the end of 2023. Only a handful of FOMC participants forecasted a similar path at the March Fed meeting. Chart 3Market Priced For December 2022 Liftoff We discussed the wide divergence between market expectations and the Fed’s “dot plot” in a recent report.2 Essentially, the divergence boils down to the Fed focusing more on actual economic outcomes while the market takes its cues from economic forecasts. We think there’s good reason for optimism about the economy, and therefore expect that the Fed will revise its interest rate forecasts higher in the coming months as the “hard” economic data improve. However, we should point out that respondents to the New York Fed’s Survey of Primary Dealers and Survey of Market Participants also have much more benign interest rate forecasts than the market, and respondents to those surveys do not share the Fed’s bias toward actual economic outcomes. Table 2 shows that the average respondent to the Survey of Market Participants only sees a 35% chance that the Fed will lift rates before the end of 2022 and the Survey of Primary Dealers displays a similar result. Table 2Odds Of A Fed Rate Hike By End Of Year The wide gap between rate hike expectations embedded in the yield curve and forecasts from both the FOMC and the New York Fed’s surveys suggests that Treasury yields are at least fairly valued, and perhaps too high. However, the most important question is whether the market’s rate hike expectations look lofty compared to our own forecast. As is explained in the below section (titled “The Employment Boom Is Just Getting Started”), we think that the jobs market will be strong enough for the Fed to lift rates before the end of 2022 and that the market’s anticipated rate hike path looks reasonable. However, even this view is only consistent with a neutral stance toward portfolio duration. Chart 4Higher Inflation Is Priced In For our final valuation indicator we focus specifically on the outlook for inflation compared to what is already priced into the forward CPI swap curve (Chart 4). The forward CPI swap curve is priced for headline CPI inflation to rise to 2.7% by May 2022 before falling back down only slightly. In reality, year-over-year headline CPI will probably spike to even higher levels during the next two months but will then recede more quickly. We think it’s reasonable to expect headline CPI inflation to be between 2.4% and 2.5% in 2022, a range consistent with the Fed’s 2% PCE target, but the forward CPI swap curve reveals that this outcome is already priced. All in all, the message from the valuation indicators in our Checklist is that a robust economic recovery is already reflected in market prices. Thus, even with our optimistic economic outlook, Treasury yields look fairly valued, consistent with an “At Benchmark” portfolio duration stance.  Cyclical Indicators While valuation indicators perform well over longer time horizons, they are notoriously bad at pinpointing market turning points. It’s for this reason that we augment our Checklist with cyclical economic indicators, specifically high-frequency cyclical economic indicators that correlate tightly with bond yields. First, we look at the ratio between the CRB Raw Industrials commodity price index and gold (Chart 5). The CRB index is a good proxy for global economic growth and gold is inversely correlated with the stance of Federal Reserve policy – gold falls when policy is perceived to be getting more restrictive and rises when policy is perceived to be easing. This ratio has shown little evidence of rolling over and further gains are likely as the economy emerges from the pandemic. We also look at other high-frequency global growth indicators like the relative performance between cyclical and defensive equities and the performance of Emerging Market currencies (Chart 5, panels 2 & 3). The trend of cyclical equity sector outperformance continues while EM currencies have shown some tentative signs of weakness. The US dollar is one particularly important indicator for bond yields. As US yields rise relative to yields in the rest of the world it makes the US bond market a more attractive destination for foreign investors. When US yields are attractive enough, these foreign inflows can stop them from rising. One good indication that US yields are sufficiently high to attract a large amount of foreign interest is when investor sentiment toward the dollar turns bullish. For now, the survey of dollar sentiment we track shows that investors are still bearish on the US dollar (Chart 5, bottom panel). Bearish dollar sentiment supports further increases in bond yields. Chart 5Cyclical Indicators Chart 6Data Surprises Still Positive Finally, we track the US Economic Surprise Index as an excellent summary indicator of the US data flow relative to market expectations. The index also correlates tightly with changes in bond yields (Chart 6). Though the index has fallen significantly from the absurd highs seen late last year, it is still elevated compared to typical historical levels. In general, bond yields tend to rise when the economic data are beating expectations, as indicated by a positive Surprise Index. All in all, we see that the cyclical indicators in our Checklist are sending a very different signal than the valuation indicators. This suggests a high probability that yields could overshoot fair value in the near term. Bottom Line: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. The Employment Boom Is Just Getting Started Chart 7Defining "Maximum Employment" The Fed has conditioned the first rate hike of the cycle on both (i) 12-month PCE inflation being at or above 2% and (ii) the labor market being at “maximum employment”. As we’ve previously written, we see strong odds that the inflation trigger will be met in time for a 2022 rate hike.3 This week, we assess the likelihood that “maximum employment” will be reached in time for the Fed to lift rates next year. Fed communications have made it clear that the FOMC’s definition of “maximum employment” is equivalent to an environment where the unemployment rate is between 3.5% and 4.5% - the range of FOMC participants’ NAIRU estimates – and the labor force participation rate has made a more-or-less complete recovery to pre-pandemic levels (Chart 7). Following March’s blockbuster employment report, we update our calculations of the average monthly nonfarm payroll growth that must occur to hit “maximum employment” by different future dates (Tables 3A-3C). Table 3AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table 3BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table 3CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date For example, to reach the Fed’s definition of “maximum employment” by December 2022, nonfarm payroll growth must average between +410k and +487k per month between now and then. To reach “maximum employment” by the end of this year, payroll growth must average between +701k and +833k over the remaining nine months of 2021. It’s probably unrealistic to expect a return to “maximum employment” by the end of this year, but we do expect at least a couple more monthly payroll reports that are even stronger than last month’s +916k. Our optimism stems from the industry breakdown of the current jobs shortfall. Table 4 shows the change in overall nonfarm payrolls between February 2020 and March 2021. In total, we see that the US economy is missing 8.4 million jobs compared to pre-pandemic. We also see that 3.1 million (or 37%) of those jobs come from the Leisure & Hospitality sector. That sector is predominantly made up of restaurants and bars, two services where demand is about to ramp up significantly as COVID vaccination spreads across the US. A few months in a row of 1 million or more jobs added is highly likely in the near future. Table 4Employment By Industry Bottom Line: We see the boom in employment as just getting started and we expect that the US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Private-sector savings exploded during the pandemic, swelling the already large global savings glut. Reluctant to sit on excess cash, households shifted some of their funds into the stock market. With corporate buybacks outpacing new share issuance, stock prices had nowhere to go but up. Falling bond yields further supercharged equity valuations. Despite the run-up in stocks, the global equity risk premium – measured as the forward equity earnings yield minus the real bond yield – still stands at about 6%, similar to where it was in late-2009. Using a simple example, we show why investors should hold more stock than the standard 60/40 rule suggests when bond yields are still this low. While bond yields will rise further over the coming years, it is likely to be a slow process. Investors should remain bullish on stocks over a 12-month horizon, favouring non-US equities over their US peers. Did A Surfeit Of Savings Lead To A Shortage Of Assets? Real interest rates have fallen dramatically since the early 1980s (Chart 1). Economic theory posits that lower real rates discourage savings while encouraging spending. Yet, as Chart 2 shows, with the exception of the late-1990s and the mid-2000s – two periods when spending was buoyed first by the dotcom bubble and then by the housing bubble – the US private sector has run a large financial surplus; that is to say, it has consistently spent less than it earned. Private-sector financial balances in most other economies have followed a similar trend. Chart 1Real Bond Yields Have Been Trending Lower Since The 1980s Chart 2The Private Sector Has Been Mostly Running Surpluses Ben Bernanke famously cited chronic private-sector financial surpluses as evidence of a “global savings glut.” The concept of a savings glut is closely related to the concept of demand-side secular stagnation, an idea popularized by Larry Summers prior to his heel-turn towards stimulus skeptic. When the private sector is unable to find enough worthy investment projects to make use of all available savings, the economy will struggle to attain full employment, even in the presence of very low interest rates. The concept of a savings glut is also related to another, less well known, concept: a safe asset shortage. If the private sector earns more than it spends, it must, by definition, accumulate assets. In principle, governments can satiate the demand for safe assets by issuing more bonds. In practice, governments have often been reluctant to run persistently large budget deficits for fear that this could undermine their credibility. Faced with a shortage of safe assets, the private sector has stepped in to fill the void, often with disastrous consequences. Most notably, in the lead-up to the Global Financial Crisis, banks sliced and diced portfolios of risky mortgages with the goal of creating safe assets that could be sold into the market. Most financial crashes occur when investors conclude that the assets they once thought were safe are not so safe after all. This was precisely what happened to mortgage-backed securities during the 2008 mortgage meltdown. The exact same pattern repeated itself two years later when investors finally came around to the seemingly obvious conclusion that Greek government bonds were not as safe as say, German bunds. The Safe Asset Shortage In A Post-Pandemic World This brings us to the present day. After falling from 7% of GDP in 2009 to 3% of GDP in the lead-up to the pandemic, the global private-sector financial balance surged to 11% of GDP in 2020. The IMF expects the global private-sector balance to average 9% of GDP in 2021 before trending lower over the coming years. Arithmetically, the private-sector financial balance must equal the sum of the fiscal deficit and the current account balance.1 By running large budget deficits during the pandemic, governments endowed the private sector with income they otherwise would not have had. This income consisted of transfers (stimulus checks, expanded unemployment benefits, business subsidies, etc.) as well as income generated from direct government spending on goods and services. As of the end of March, we estimate that US households had accumulated about $2.2 trillion (10.5% of GDP) in savings over and above what they would have had in the absence of the pandemic. About 40% of those “excess savings” stemmed from fiscal policy with the remainder reflecting decreased consumption (Chart 3). Chart 3Lower Spending And Higher Income Have Led To Mounting Savings Chart 4Government Largesse Boosted Savings And Fattened Bank Deposits As the private sector’s financial balance increased, so did its asset holdings. Unlike in normal fiscal expansions where governments fund budget deficits by selling debt to the public, this time around, governments largely sold the debt to central banks. The money that governments received from central banks in return was then pumped into the economy, leading to a surge in bank deposits (Chart 4).   The Nature Of Stock Market “Flows” What happened to the money after it reached people’s bank accounts? A popular narrative is that some of it flowed into the stock market. While this description is technically true, it is somewhat misleading in that it conveys the false impression that there was a net inflow of money into stocks. The reality is more nuanced. When I buy some stock, I gain some shares but lose some cash. Conversely, whoever sold me the stock gains some cash and loses some shares. In aggregate, there is no change in either the number of shares or the amount of cash that investors hold. What does change is the value of the shares in relation to the cash that investors hold. My purchase must lift the share price by enough to persuade someone else to part with their shares. If the seller does not want to hold the additional cash, he or she may try to place an order to purchase a different stock that appears more attractively priced. This game of hot potato will only end when the value of the stock market rises by enough that all investors are happy with how much stock they own in relation to how much cash they hold. Rethinking The 60/40 Split The standard investment mantra is that investors should hold 60% of their portfolios in stock and the rest in cash, bonds, and other financial assets. The discussion above casts doubt on this simple rule of thumb. Suppose that Melanie holds $600 in stock and $400 in cash, and that cash earns a real interest rate of 2%. Let us also assume that Melanie requires a 4% equity risk premium. Hence, the equity earnings yield must be 6% (i.e., her $600 in stock must correspond to $36 in earnings).2 Now let us suppose that the central bank cuts the policy rate, so that the real interest rate falls to zero. In order to maintain a 4% equity risk premium, the earnings yield must decline to 4%, which implies that the value of the stock must rise to $900 ($36/0.04=$900). Thus, we have gone from a position where Melanie holds 60% of her portfolio in stock to one where she holds about 69% ($900/$1300) in stock. In other words, even though the equity risk premium did not change at all, the desired ratio of stock-to-cash rose from $600/$400=1.5 to $900/$400=2.25. Let us continue the thought experiment and imagine a scenario where the government sends Melanie and everyone else a stimulus check of $100. Now she has $500 in cash and $900 in stock. If she wants to maintain a stock-to-cash ratio of 2.25, she would need to use some of her cash to buy stock. However, since everyone else is also looking to purchase stock with their stimulus checks, before Melanie has a chance to enter a buy order, she finds that the stock in her portfolio has appreciated to $1125. Since $1125/$500 is equal to 2.25, Melanie cancels her buy order, content with the knowledge that she holds as much stock as she wants. Notice that in this simple example, neither interest rate cuts nor stimulus checks did anything to boost corporate profits. All that happened is that stock prices rose, causing the equity earnings yield to first fall from 6% to 4% after the central bank cut rates, and then fall again from 4% to 3.2% ($36/$1125) after the stimulus checks were sent out. If all of this sounds a bit familiar, it should. The sequence of events described above is precisely what has happened over the past 12 months. And not just to stock prices. As interest rates fell and cash balances swelled, other risky assets such as cryptocurrencies went to the proverbial moon. Is The Party Over? Given that fiscal stimulus has peaked and interest rates cannot be cut any further in the major economies, are stocks set to fall? Not necessarily! The amount of stock that investors choose to hold in relation to their cash balances is a function of animal spirits. While US consumer confidence rebounded in March to the highest level in a year, it still remains well below pre-pandemic levels (Chart 5). The percentage of households in The Conference Board’s survey who expect stock prices to rise over the next 12 months is still around its long-term average (Chart 6). Chart 5Stocks Could Rise Further As Confidence Recovers Chart 6The Percentage Of Households Who Expect Stock Prices To Rise Over The Next 12 Months Is Still Around Its Long-Term Average Fortunately, the US is on target to provide a vaccine shot to everyone who wants one by the end of April.3 As the economy continues to reopen, confidence will rise further. Rising confidence, in turn, may prompt investors to increase their equity holdings. Our US equity strategists expect share buybacks to exceed share issuance over the next 12 months. Thus, the value of equity portfolios will only be able to rise if share prices go up. Outside the US and the UK and a few other smaller economies, the vaccination campaign has gotten off to a rocky start. However, the pace of inoculations is set to accelerate rapidly in the second quarter, which should pave the way to faster global growth. Global equities usually outperform bonds when growth is on the upswing (Chart 7). Chart 7Stocks Usually Outperform Bonds When Economic Growth Is Strong While equity allocations have risen, they are below the level reached in 2000 (Chart 8). Back then, the global equity earnings yield was on par with the real bond yield. Today, the earnings yield is about six percentage points above the bond yield, a similar gap to what prevailed in late-2009 (Chart 9). Chart 8Stock Allocations Have Rebounded, But Remain Below Their 2000 Peak Chart 9The Equity Risk Premium Is At Levels Similar To Late-2009 Granted, today’s high equity risk premium largely reflects the exceptionally low level of bond yields. If bond yields were to move up, the equity risk premium would shrink. While we do think that bond yields will rise by more than expected in the long run, the path to higher yields is likely to be a slow one. Rate expectations 2-to-3 years out tend to move closely in line with the 10-year yield (Chart 10). Already, there is a large gap between market expectations and the Fed dots. Whereas the market expects the Fed to start lifting rates late next year, the median Fed “dot” continues to signal no rate hike at least until 2024 (Chart 11). It is unlikely that market expectations will shift towards an even more aggressive path of rate tightening unless the Fed’s dovish rhetoric turns hawkish. As we discussed in our recently published Second Quarter Strategy Outlook, we do not expect this to happen anytime soon. Thus, with monetary policy still very loose, stocks can continue to grind higher. Chart 10Bond Yields Are Unlikely To Rise Much Unless The Market Lifts Its Estimate Of Where The Fed Funds Rate Will Be 2-To-3 Years Out   Chart 11A Wide Gap Has Opened Up Between Market Expectations And The Fed Dots Regionally, we favour stock markets outside the US. Not only will overseas markets benefit from a rotation in growth from the US to the rest of the world in the second half of this year, but US corporate tax rates are almost certain to rise. We will be exploring the tax issue over the coming weeks.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Just as the private-sector financial balance is the difference between what the private sector earns and spends, the fiscal balance is the difference between what the government earns and spends. If the fiscal balance is negative, the government runs a deficit. If the fiscal balance is positive, the government runs a surplus. Thus, added together, the private-sector financial balance and the fiscal balance simply equals the difference between what the country as a whole earns and spends which, by definition, is equal to the current account balance. One can also see this point by rewriting the equation Y=C+I+G+X-M as (Y-T)-(C+I)=(G-T)+(X-M) where T is tax revenue, Y-T is private-sector earnings, C+I is what the private sector spends on consumption and capital goods, G-T is the fiscal deficit, and X-M is the current account balance, broadly defined to include not only the trade balance but also net income from abroad. 2 The relative attractiveness of stocks can also be inferred by subtracting the real bond yield from the earnings yield on stocks in order to get an implied equity risk premium (ERP). It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3 Mia Sato, “The US is about to reach a surprise milestone: too many vaccines, not enough takers,” MIT Technology Review, March 22, 2021. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF 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 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced Chart 2US Natgas Inventories Return To Five-Year Average US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing Chart 4US LNG Exports Set Records In November And December 2020 US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Chart 10       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Highlights Our 80% odds that Biden will pass the $2.3 trillion American Jobs Plan stem from public opinion as well as Democratic control of Congress. Voters favor both higher taxes on corporations and higher infrastructure spending, as well as Biden’s proposal to pay for the latter by means of the former. A bipartisan consensus favors infrastructure spending, including “soft” infrastructure. Republicans who campaigned on the need for infrastructure over the past five years will not gain voter support by opposing it now. The Senate parliamentarian’s recent ruling on budget reconciliation procedures enables the Democrats to pass a second reconciliation bill, as expected. This puts Biden’s American Families Plan, to be detailed this month, officially into play for FY2022. Our initial premise remains a 50/50 chance that the $1.9 trillion bill passes before the 2022 midterms. Infrastructure plays benefit from a rising budget deficit but will also face a global headwind as China’s stimulus and growth momentum wane. Feature The market cheered the Biden administration’s $2.3 trillion American Jobs Plan despite the confirmation that corporate tax rates will go up as expected (Chart 1). The details of the plan are shown in Table 1, which makes it clear that $760 billion can easily be subtracted from the plan during negotiations as not having to do with infrastructure. However, investors should wager that most of the new spending, including the social welfare components, will pass, since Democrats will use the budget reconciliation process. Chart 1Market Response To Biden, Infrastructure, Tax Hikes Table 1Biden's 'American Jobs Plan' The bigger question is tax hikes. Senator Joe Manchin of West Virginia reiterated that a 25% corporate tax rate is as high as he is willing to go. Since Democrats cannot spare a single vote in the Senate (not to mention six or seven votes, which Manchin claims to have on his side), the corporate tax rates may be compromised. Still, investors should prepare for the worst, i.e. the 28% rate that Biden presented or only slightly less. While Manchin is the critical marginal voter – his vote will turn the balance of power in the Senate – nevertheless there will be enormous pressure on him not to “betray” his party and vote against the signature legislative proposal of the Biden presidency. Insofar as Manchin succeeds, he presents a “less bad” outcome for equity sectors that stand to suffer the most from a higher headline corporate tax rate, such as utilities, health care, and information technology (Chart 2). Chart 2Corporate Tax Rates Will Rise To 25%-28%, A Big Increase For Real Estate, Health Care, Tech, Utilities, And Consumer Staples It will take time to draft and negotiate the spending and tax provisions and then get them passed in both the House and Senate. The Democrats also face tight margins in the House, where they can only lose four votes (the balance in the House is 218-211 after the death of Florida Representative Alcee Hastings). The earliest possible passage – based on historical precedent – is in May. The average length of time would put passage in November. In the worst case the negotiations could drag on till Christmas but we highly doubt the Democrats will take that long (Diagram 1). We attach an 80% subjective probability to the view that the American Jobs Plan will pass by end of year. Diagram 1Time Line For Congress To Pass American Jobs Plan By End Of 2021 Where we are less certain is in the second part of Biden’s economic plan, the $1.9 trillion American Families Plan, which contains social welfare spending, an expansion of the child tax credit and other tax cuts for the lower and middle classes, and the tax hikes on upper-middle class and wealthy individuals and households. This program will be outlined this month. It will be a challenge to pass it prior to the 2022 midterm elections, depending on how fast infrastructure flies through Congress. Our subjective 50% odds received initial support on April 5 when the Senate parliamentarian, Elizabeth MacDonough, ruled that the Democrats can indeed pass more than one budget reconciliation bill per fiscal year, contrary to previous practice. This bill is just as likely to be the Democratic campaign platform for 2022 as to be passed in early 2022 under the current Congress. Senate Parliamentarian Enables Democrats To Bypass Filibuster We must pause here to note that the parliamentarian’s ruling is highly consequential as it erodes the checks and balances on passing legislation in the Senate. The new ruling holds that under Section 304 of the Congressional Budget Act of 1974 the annual budget resolution can be revised. If it can be revised, then a new budget reconciliation bill can be crafted according to the new budget resolution. And reconciliation enables the ruling party to push through bills on a simple majority (51 votes) in the Senate. It will be hard for the Senate, as a body, to limit the ramifications of this decision in future. If the Democrats can pass two reconciliation bills in FY2021, then who is to say that some later Congress cannot pass three? Regardless, it is hard for a party to pass more than three major pieces of legislation in a single year, so the window is just wide enough to enable major breakthroughs in legislation (and, whenever the opposing party regains the House and Senate, big reversals of legislation). We have argued that Democrats would eventually, if not immediately, remove the Senate filibuster (the rule that requires 60-votes to end debate on regular legislation). At the moment there are still not enough votes to remove the filibuster entirely, although moderate Democrats are looking at technical ways of diminishing its influence, such as via the “talking filibuster” that would increase the difficulty of the process and thus reduce its use in the Senate.1 But this new ruling on budget reconciliation process substantively bypasses the filibuster. While the reconciliation process will still come with various technical limitations (the “Byrd rule,” and relevance to the budget), they are pliable. Clearly the ruling party calls the shots – especially if it is a party in synch with the political establishment in Washington. The Public Favors Tax Hikes For Infrastructure Where do we get our 80% subjective probability that Biden’s American Jobs Plan will pass Congress? Why so confident? First, Democrats have control of Congress, albeit narrowly. Second, public opinion not only favors infrastructure but also favors tax hikes on corporations – especially if they are to pay for infrastructure. The solution has been to rebrand renewable energy, broadband Internet, subsidized housing, and a range of other government programs as “infrastructure,” and meanwhile to rebrand social welfare as “human infrastructure.” Consider the following: The public favors higher taxes on corporations: 69% of Americans believe corporations pay too little in taxes, while only 6% believe they pay too much (Chart 3). While this is a general view, and does not reflect regional variations, it calls into question Joe Manchin’s opposition to a corporate tax rate of 28%. Manchin has his eye on the economic recovery, small business owners, as well as the particular industries and political orientation of his state. But the point is that opposition to corporate tax hikes is politically weak and therefore we continue to expect the result to be closer to Biden’s 28% than to Manchin’s 25%. The public favors higher taxes on high-income earners: As for Biden’s second slate of tax hikes, on individuals and households under the yet-to-be detailed American Families Act, 62% of Americans believe that upper-income earners pay too little in taxes and again only 9% believe they pay too much (Chart 4). Since Biden’s proposals amount to only a partial repeal of President Trump’s Tax Cut and Jobs Act, which was itself unpopular in opinion polling, investors should also have a presumption in favor of individual tax hikes. However, as noted above, the American Families Plan only has a 50% chance of passing prior to the midterms due to the time crunch. Chart 3Public Favors Tax Hikes On Corporations Chart 4Public Favors Tax Hikes On The Rich Government is not seen as incompetent on infrastructure: Net public approval of the government’s performance on infrastructure is positive, just barely, unlike immigration, health care, or the environment. This means Biden can tap into a greater level of trust in government on this policy, while still calling on a general belief that infrastructure needs to be improved (Chart 5). Chart 5Public Gives Government Decent Grades On Infrastructure Chart 6No Partisan Gap On whether Infrastructure Should Be Prioritized Infrastructure is bipartisan: The gap in the views of Republicans and Democrats is narrow when it comes to infrastructure, unlike other policy issues that are extremely polarized. The gap is narrow whether infrastructure should be prioritized (Chart 6), whether government should play a larger role (Chart 7), and whether the federal government does a good job in this area (Chart 8). Democrats are more supportive of these propositions and they are currently in charge. But even Republicans tend to agree, as indicated by President Trump’s own emphasis on infrastructure, which the grassroots of his party supported despite establishment Republican hesitations due to concerns about the deficit. These charts also suggest that voters, especially Democratic voters, will not be bothered by the presence of non-traditional or “soft” infrastructure in Biden’s package as long as it can be successfully pitched as helping the economy, jobs, and American supply chains. Chart 7Government Role In Infrastructure Not Too Partisan Chart 8Government Performance On Infrastructure Not Too Partisan The public approves of Biden’s corporate-tax-hikes-for-infrastructure tradeoff: About 54% approve outright, in line with Biden’s overall approval rating, including 52% of independents and a non-negligible 32% of Republicans. A further 27% support infrastructure spending without raising taxes, including 42% of Republicans (Chart 9). This poll does not stand alone but corroborates a range of polling over the past decade on both taxes and infrastructure. It strongly implies that the median voter will support Biden’s plan. (And again it suggests that while Senator Manchin may turn the balance in the Senate he is not standing on solid rock in calling for Biden to pare back his corporate tax hikes.) Chart 9Voters Back Tax Hikes For Infrastructure No need to rely on polling – look at how people vote: Ballot measures on the local level for transportation funding usually win high levels of voter approval, meaning that people vote to increase their own taxes if they think traditional infrastructure will be improved. The average approval for such measures stood at 74% in 2016 and rose to 94% in the 2020 election cycle (Chart 10). And voters clearly understood that this combination is what they would get in voting for Biden, given that he did not shy away from his tax proposals in the presidential debates (although he insisted no tax hikes on those who earn less than $400,000 per year). Chart 10Voters Accept Higher Taxes For Infrastructure The Democrats have the votes for an infrastructure package, they have the votes for at least some degree of corporate tax hikes, and they have popular opinion behind the principle of tax hikes in exchange for infrastructure upgrades. Furthermore the rise of geopolitical struggle abroad and populism at home have given Biden and the traditional Democrats extraordinary impetus to pass this bill. If they fail, they will have wasted precious congressional time, they will be less likely to pass the American Families Plan, and they will be more likely to lose control of the House or even the Senate in 2022, as their failure would energize both the democratic socialists on their left and the Trump Republicans on their right. It is unlikely that Senator Manchin alone is willing or able to cause such a train wreck for his party given the popularity of the proposals.2 The implication is that corporate tax hikes will be compromised only somewhat. It is also possible that non-infrastructure components of the bill, such as housing or some social spending, could be pared back, although these are not the controversial parts of the bill and we would not bet on the overall size of spending to be reduced by much. A bill with Biden’s spending measures and only half of the tax hikes would increase the budget deficit by $1.4 trillion, as we showed last week. A bill with all spending and all tax hikes would increase the deficit by $400 billion. Bottom Line: Biden has an 80% chance of passing the American Jobs Act, although some non-infrastructure provisions could be pared back and the corporate tax hike may not reach all the way to 28%. Most likely the final bill will be substantially similar to Biden’s proposal on spending, while the tax hikes will be compromised, reflecting the populist and proactive fiscal turn in US politics. Investment Takeaways A basket of the 50 companies in the S&P 500 with the highest median effective tax rates outperformed the S&P500 upon Trump’s election and subsequent tax cuts (Chart 11). Since Biden’s election they have also outperformed on the expectation of post-pandemic reopening and economic stimulus. However, the high-tax companies and high-tax sectors have underperformed on an equal-weighted basis since the Democratic Party won control of the Senate and tax hikes became inevitable. Tax hikes are largely but not fully priced from this point of view. Historically a rising budget deficit does not have a clear or positive correlation with the S&P 500, cyclical sectors, value stocks, or small caps. Fiscal thrust normally surges during recessions and bear markets. Nevertheless infrastructure plays – by which we include building products, construction materials and services, environmental services, metals and mining, machinery, and steel – tend to perform better when the deficit blows out. That trend looks to be intact today (Chart 12). Chart 11High-Tax Companies Rallied Despite Biden's Tax Hikes (But Not On Equal-Weighted Basis) Chart 12US Budget Blow-Out Positive For Infrastructure Plays The budget deficit is generally a stronger predictor of the performance of these sub-sectors than global manufacturing surveys and leading economic indicators, although the improvement in global sentiment and growth is clearly a positive backdrop (Chart 13). Europe and countries other than China will soon improve their vaccinations, reopen, and start catching up to the US economic rebound. China’s fiscal-and-credit impulse is closely correlated with US infrastructure plays and this has not changed since the trade war began (Chart 14). Importantly, China is tapping on the policy brakes and its economy is set to decelerate in the second half of the year, which has important implications for our BCA Infrastructure Basket and long trades. This indicator suggests that the relative performance of infrastructure plays will face a gradually rising headwind from abroad even as the US economy continues to provide a tailwind. Chart 13Global Sentiment Positive But Not A Big Driver Of US Infrastructure Plays Chart 14Infrastructure Plays Face Headwind From China's Waning Stimulus Infrastructure plays shown here – which consist of goods and services that fall under greater demand when infrastructure is built – should not be confused with infrastructure companies themselves, which tend to be classified under the much more defensive utilities and telecommunication sectors (Chart 15). This ratio is looking very toppy, in keeping with the general rollover in cyclical equity sector performance relative to defensives.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 15Infrastructure Plays Versus Utilities And Telecoms   Appendix Table A1Political Risk Matrix Table A2Political Capital Index Table A3APolitical Capital: White House And Congress Table A3BPolitical Capital: Household And Business Sentiment Table A3CPolitical Capital: The Economy And Markets Table A4Biden’s Cabinet Position Appointments   Footnotes 1     Molly E. Reynolds, “What is the Senate filibuster, and what would it take to eliminate it?” Brookings Institution, September 9, 2020, brookings.edu. 2     On the contrary, while the bill will pass via party-line voting, it is still conceivable that one or two moderate Senate Republicans could be brought to endorse Biden’s American Jobs Plan.