UK

Highlights Global Tapering: The Bank of England has joined the Bank of Canada as central banks tapering the pace of bond buying. Markets are now trying to sort out who is next and concluding that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. US Treasury Curve: We are adding a new recommended US butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell using US Treasury futures. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime. Feature Heading into 2021, one of our key investment themes for the year was that no major central bank would shift to a less dovish monetary policy stance before the Fed. Not even five months into the year, our theme has already been proven incorrect. Last week, the Bank of England (BoE) announced a slower pace of its asset purchases, following a similar tapering decision by the Bank of Canada (BoC) last month. Chart of the WeekUS Jobs Recovery Lagging, Despite Vaccine Success We had assumed that no central bank could tolerate the currency strength that would inevitably occur by tapering ahead of the Fed. That was clearly not the case in Canada, and the Canadian dollar has already appreciated 4.6% versus the greenback since the BoC taper announcement April 21. The British pound also rallied solidly against both the US dollar and euro immediately after the BoE taper announcement last week. Markets are beginning to speculate on future taper candidates, like the Reserve Bank of New Zealand (RBNZ), with the New Zealand dollar being one of the strongest currencies in the G10 versus the US dollar since the end of March (+4.4%). Investors had been debating the possibility that the Fed could begin tapering sometime in the second half of 2020, largely based on what has to date been a successful US vaccination campaign. Yet while that led to optimism that the US economy can quickly reopen and return to normal, the fact remains that the recovery in US employment from the COVID shock has lagged other major economies (Chart of the Week). The big downside miss on the April US payrolls report highlights how the Fed can be patient before joining the tapering club. US Treasury yields are likely to continue trading sideways, and the US dollar will trade soft, until markets can sort out the true state of US labor demand versus supply. Which Central Bank Could Follow The BoC And BoE? Back in March, we published a report that discussed what we called the “pecking order of global liftoff”.1 We looked at how interest rate markets were pricing in an increasingly diverse path out of the coordinated global monetary easing enacted last year during the COVID recession (Chart 2). We looked at both the timing of “liftoff” (the first rate hike) and the pace of hikes afterward to the end of 2024. We then ranked the countries by the market-implied timing of liftoff. Chart 2Sorting Out The Relative Hawks & Doves Among Global CBs At the time, overnight index swap (OIS) curves were discounting the earliest liftoff from the RBNZ (June 2022) and BoC (August 2022). The Fed was expected to hike in January 2023, followed by the BoE in June 2023 and Reserve Bank of Australia (RBA) in July 2023. The European Central Bank (ECB) and Bank of Japan (BoJ) were the laggards, with no rate hiked discounted until September 2023 and February 2025, respectively. In terms of the pace of rate hikes after liftoff through 2024, our list was broken into two groups. The more aggressive central banks were expected to be the BoC (+175bps), RBA (+156bps), RBNZ (+140bps) and the Fed (+139bps). Much smaller amounts of rate hikes were anticipated from the BoE (+63bps), ECB (+25bps) and BoJ (+9bps). In the two months since our March report, the market timing of liftoff, and the pace of subsequent hikes, has shifted for all those countries (Table 1). The BoC is now expected to move in September 2022, ahead of the RBNZ (October 2022). In 2023, the Fed is now priced for liftoff in March 2023, followed by the BoE and RBA (both in July 2023). The ECB liftoff date is little changed (now August 2023), while the market has dramatically pushed out the timing of any BoJ hike (now November 2025). The cumulative rate hikes through 2024 are moderately lower for all countries except Australia (a reduction in total tightening of 56bps). Table 1The Fed Is Sliding Down The “Pecking Order Of Liftoff” List What is interesting about these changes is that the market has pulled forward the timing of liftoff for the BoE and RBA, while pushing it out for the BoC, RBNZ, BoJ and, most importantly, the Fed. The Fed is now drifting down the “pecking order” for liftoff, expected to lift rates only a couple of months before the BoE or RBA. This is a major change from previous monetary policy cycles, when the Fed would typically be a first mover when it comes to tightening policy. Chart 3The Momentum Of Global QE Has Already Been Slowing While the BoC and BoE decisions to taper quantitative easing (QE) have garnered the headlines, the pace of global central bank balance sheet expansion had already peaked at the start of 2021 (Chart 3). The pace has slowed most dramatically in Canada and the US, but this was a result of certain emergency programs expiring – most notably the Fed’s corporate bond buying vehicles late last year and the BoC’s short-term repo facilities more recently. Greater financial market stability was the reason cited to end those programs, while still leaving government bond QE buying in place unchanged. The year-over-year pace of global QE was set to slow, simply from less favorable comparisons to 2020 after the surge in central bank balance sheet expansion last year. Yet now we are starting to see actual tapering of government bond purchases from some central banks. Is such “early tightening” warranted? Back in that same March report where we discussed the order of global liftoff, we gave our assessment of the most important factors that could drive central banks to consider a shift to a less dovish stance (like tapering). For the BoC, we cited booming house prices and robust business confidence as reasons the BoC could turn less dovish sooner (Chart 4). For the BoE, we noted a sharper-than-expected recovery in domestic investment and consumer spending, as the locked-down UK economy reopens, as reasons why the BoE could begin to tweak its policy settings. For both central banks, all those indicators were mentioned as factors leading to their decision to taper. For the Fed, we determined that rising inflation expectations and increasing labor market tightness would both be required for the Fed to turn less dovish. Only inflation expectations have reached that goal, with the US Employment/Population ratio still well below the pre-pandemic peak (Chart 5). For the RBA, we looked solely at realized inflation measures, as the RBA has explicitly noted that Australian wage growth must rise sustainably towards 3% - nearly double current levels - before realized CPI inflation could return to the 2-3% target range. For both the Fed and RBA, the necessary conditions for a change in current policy settings have not yet been met. Chart 4What The More Hawkish CBs Are Watching Chart 5What The More Dovish CBs Are Watching For the ECB, we noted that realized inflation (and the ECB’s inflation forecasts), along with the Italy-Germany government bond spread as a measure of financial conditions, were the most important indicators to watch before the ECB could consider any move to taper its QE programs (Chart 6). Italian spreads have widened a bit in recent months, while the latest set of ECB economic forecasts still call for headline euro area inflation to remain well south of the 2% target out to 2023. For the BoJ, we simply cited a rise in realized inflation as the only possible development that could lead to a BoJ taper. The BoJ now forecasts that Japanese inflation will not reach the 2% central bank target until at least 2024. So for both the ECB and BoJ, the conditions do not warrant any imminent tapering of bond buying. Chart 6What The Most Dovish CBs Are Watching As another way to determine who could taper next, we turn to our Central Bank Monitors, which are designed to measure the pressure on policymakers to ease or tighten monetary setting. All the Monitors have responded to the recovery in global growth and inflation, along with the easing of financial conditions implied by booming markets, over the past year. Yet only the RBA Monitor is calling for tightening (Chart 7), indicating that the RBA’s current focus on only wages and realized inflation is a departure from their behavior in the past. The Fed and BoE Monitors have risen to the zero line, suggesting no further pressure to ease policy but no tightening is needed either. The ECB, BoJ and RBNZ Monitors are all close, but just below, the zero line, suggesting diminishing need for more monetary stimulus (Chart 8). Chart 7Bond Yields Have Moved Ahead Of Our CB Monitors Chart 8Yields Overshooting Tightening Pressures Here Too Based on our assessment of the above indicators, we judge the RBNZ to be the next central bank most likely to taper, sometime in the 2nd half of 2021. We still see the Fed starting to signal tapering later this year, but with actual slowing of US Treasury (and Agency MBS) purchases not occurring until early 2022. The year-over-year momentum of bond yields correlates strongly with the Central Bank Monitors. The rise in global bond yields seen over the past year has exceeded the pace implied by the Monitors. This is unsurprising given how rapidly the global economy has recovered from pandemic-fueled recession in 2020. Supply chain disruptions and surging commodity prices have also given a lift to bond yields via rising inflation expectations, even as central banks have promised to keep rates on hold for at least the next couple of years. Yet purely from a monetary policy perspective, the surge in global bond yields looks to have gone a bit too far, too fast. Bottom Line: Markets are now trying to sort out who will taper next after the BoC and BoE, and have concluded that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. Bond yields in other developed markets appear to have overshot economic momentum, and a period of consolidation is needed before yields can begin moving higher again. US Treasury Curve: How Much Steepening Left? Chart 9A Pause In The UST Bear-Steepening Trend For most of the past year, the primary trend in the US Treasury curve has been one of bear steepening. Longer maturity yields have borne the brunt of the upward pressure stemming from the rapid recovery in US (and global) economic growth from the depths of the 2020 COVID-19 recession. In recent weeks, however, the surge in longer-maturity Treasury yields has stalled, as have the immediate steepening pressures (Chart 9). Purely from a fundamental economic perspective, a steepening Treasury curve is an expected result of the reflationary mix of growth, inflation and monetary policy currently at work in the US. For example, since the 2020 lows, 5-year/5-year forward inflation expectations from the TIPS market have risen 143bps while the ISM manufacturing index surged from a low of 41 to a high of 65 in March of this year (Chart 10). Combine that with the Fed cutting rates to 0% last year, while promising to keep rates unchanged through 2023 and reinforcing that commitment through QE, and it is no surprise to see a steeper US Treasury curve. Chart 10UST Curve Steepening Has Been Driven By Reflation Yet even despite these obvious steepening pressures, the pace of the Treasury curve steepening does seem to be a bit rapid compared to history. In Chart 11, we show a “cycle-on-cycle” analysis, comparing the slope of various US Treasury curve segments (2-year versus 5-year, 5-year versus 10-year, 10-year versus 30-year) to the average of the previous five US business cycles, dating back to the 1970s. The curves are lined up to the start date of the previous recession, with the vertical line in the chart representing that date. Thus, this chart allows us to see how the Treasury curve evolved heading into, and coming out of, economic downturns. Chart 11 shows that the current 2-year/5-year curve, with a steepness of 63bps, is in line with past steepening moves coming out of recession. For the curve segments at longer maturities, the pace of steepening has been much more rapid than in the past. In fact, the current 5-year/10-year slope of 82bps is already above the average past peak level, as is the 10-year/30-year curve of 72bps. If we do the same cycle-on-cycle analysis for the three previous US recessions dating back to 1990, the current curve slopes are more in line with levels seen one year into the economic expansion (Chart 12). During those previous cycles, the curve steepening trend ended around two years into the expansion. This suggests that the current curve steepening could continue into 2022, except for one major difference – the Fed cut rates to 0% very rapidly last year, far faster than in the previous easing cycles. This suggests that additional curve steepening from current levels can only occur through a surge in US inflation. Chart 11Current UST Steepening Has Moved Fast Compared To Past Cycles Chart 12Can More UST Curve Steepening Occur With A 0% Funds Rate? The slope of the Treasury curve is typically correlated to the level of the nominal fed funds rate, but is even more strongly correlated to the funds rate minus actual inflation, or the real fed funds rate. When the real funds rate is below the natural real rate of interest, a.k.a. r-star, the Treasury curve has historically exhibited its strongest steepening trend. That can be seen in Chart 13, where we show the real fed funds rate (adjusted by US core CPI inflation) compared to the New York Fed’s estimate of r-star. The gap between the two series is shown in the bottom panel, correlating very strongly to the 2-year/30-year Treasury curve slope. Chart 13Curve Steepening Results When Real Rates Are Below R* With the nominal funds rate at zero, that gap between r-star and the real fed funds rate can only widen in a fashion that would support more curve steepening if a) realized US inflation moves higher or b) r-star moves higher. Both outcomes are possible as the US economic recovery, fueled by expanding vaccinations and fiscal stimulus. Both real rates and r-star are much lower in the current cycle than in previous economic recoveries, although the r-star/real funds rate gap appears to be following a more typical path that suggests potential additional steepening pressure (Chart 14). The wild card in this analysis is the Fed itself. If US economic growth and inflation evolve in way that makes it more likely the Fed would have to begin tapering QE and, eventually, signal future rate hikes, the Treasury curve may shift to a more typical bear-flattening trend seen during tightening cycles. We saw an example of that after the release of the March US employment report, where over a million jobs were created in a single month, causing 5-year Treasury yields to jump higher than longer-maturity Treasuries (i.e. curve flattening). Looking ahead, it appears that the US yield curve is more likely to slowly transition to a bear-flattening/bull-steepening regime than continue the bear-steepening/bull-flattening: trend of the past twelve months. One way to position for this is to enter into butterfly curve trades that offer attractive carry or valuation. For that, we turn to our Treasury curve valuation models. We have been recommending a Treasury yield curve trade in our Tactical Overlay portfolio on page 19, going long a 7-year bullet versus going short a 5-year/10-year barbell (Chart 15). This barbell is now very cheap on our models, which measure value by regressing the butterfly spread on the underlying slope of the curve. In this case, the spread between the 5/7/10 butterfly is unusually wide compared to the slope of the 5/10 Treasury curve. According to our model, this butterfly spread discounts nearly 100bps of additional 5/10 steepening, an excessive amount compared to past cycles. Chart 14R* - Real Funds Rate Gap Below Previous Cyclical Peaks Chart 15Maintain Our Current 5/7/10 UST Butterfly Trade While the valuation is attractive on the 5/7/10 butterfly (Table 2), the carry on this position is a modest 12bps. A butterfly with more attractive carry is the 2/5/30 butterfly. Table 2US Butterfly Strategy Valuation: Standardized Residuals Table 3US Butterfly Strategies: Carry Chart 16Enter A New 2/5/30 UST Butterfly Trade This butterfly has a neutral valuation (Chart 16) on our model, but offers 35bps of carry - the most attractive among all butterflies involving a 5-year bullet (Table 3). With US Treasury yields, and the Treasury curve slope, likely to remain rangebound for the next few months, going for higher carry trades is an attractive strategy – particularly if used in conjunction with a below-benchmark duration stance, which we still advocate. The 2/5/30 butterfly represents an attractive near-term hedge to that more defensive duration posture. Bottom Line: We are adding a new recommended US Treasury butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis.  Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks Table 3A Bullish Backdrop For EUR/USD The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9).  Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February.  The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More Chart 12Accelerating UK Inflation   Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains.  It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Chart 16Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance​​​​​​​ Closed Trades

Special Report

Highlights The Scottish parliamentary election does not present a near-term risk of a second referendum on Scottish independence. Independence is possible down the road but very unlikely due to a host of economic and geopolitical challenges still relevant in the twenty-first century. Book gains on long CHF-GBP. Go long FTSE 100 versus developed markets excluding the United States. Feature British equities have underperformed developed markets over the past decade – even if we exclude the market-leading United States (Chart 1). The British equity market is heavily concentrated in cyclical sectors like financials and materials and has a low concentration in information technology and communications services. As such the bourse has sprung to life since the advent of the COVID-19 vaccine and the prospect of a government-stimulated global growth recovery. In keeping with our strategic preference for value over growth we also look constructively at British equities. A potential source of geopolitical and political risk is Britain’s ongoing constitutional crisis, which flared up with the failed Scottish independence referendum in 2014 and the successful referendum to leave the EU in 2016. Tensions within the UK and between the UK and EU are part of the same problem – a loss of popular confidence and trust in the current nation-state and governing institutions in the aftermath of hyper-globalization.1 This constitutional crisis added insult to injury for UK stocks by jacking up policy uncertainty and undermining the attractiveness of domestic-oriented UK companies that suffered from trade disruptions with the European Union. Chart 1UK Referendums Added Insult To Injury Chart 2Post-Brexit Trading Range For GBP-EUR Now the COVID-19 pandemic and its aftermath have changed the global scene entirely and Brexit is no longer Britain’s chief concern. But there is still a lingering question over Scotland’s status. The Scottish question has recently weighed on the British pound and reinforced the new trading range for the GBP-EUR exchange rate in the aftermath of a “hard” exit from the European Union (Chart 2). Scotland voted for a new parliament on May 6 and the preliminary results are coming in as we go to press. The pro-independence Scottish National Party is still the most popular party and even if it falls short of a majority, as online betting markets expect, it has pro-independence allies with which it could form a coalition (Chart 3). Its leader, Scottish First Minister Nicola Sturgeon, has promised to pursue a second popular referendum on seceding from the United Kingdom by 2023. Chart 3Betting Markets Doubt Single-Party Majority For SNP British Prime Minister Boris Johnson, backed by a strong Conservative Party parliamentary majority, has vowed not to allow a second referendum, arguing that the 2014 plebiscite was supposed to lay the question to rest for a while. Scottish opinion in favor of secession stands at 43.6% today, right near the 44.7% that nationalists achieved in 2014 (Chart 4). Chart 4Support For Independence Ticks Down, Still Shy Of Majority Our takeaway is to fade the Scottish risk. Book gains on our long CHF-GBP tactical trade. Go long British equities relative to DM-ex-US on the expectation of global economic normalization, which is beneficially for the outwardly oriented British multinationals that dominate the British bourse. Does Scotland Have Grand Strategy? The history of Scotland is marked by internal differences that prevent it from achieving unity and independence. Even in the twenty-first century, when many factors have coalesced to make Scottish independence more likely than at any time since the eighteenth century, the 2014 referendum produced a 10% gap in favor of remaining in the United Kingdom. This majority is all the more compelling when viewed from the perspective of geography because cross-regional support for the union is clear (Map 1). Map 1Scottish Independence Referendum Result, 2014 Why is Scotland always divided? Because it is trapped by the sea and adjacent to a greater power, England. England is usually strong enough to keep Scotland from consolidating power and asserting control over its maritime and land borders. Specifically, Scotland contains a small population (at 5.5 million today) and small economic base (GBP 155 billion in economic output at the end of 2022) dispersed over an inconvenient geography. The low-lying plains around the Firth of Forth that form the historic core of Scotland share a porous border with England. The highlands provide a retreat for Scottish forces during times of conflict, which makes it extremely difficult for southern forces, whether Roman or Anglo-Saxon, to conquer Scotland. But the highlands are equally hard for any standalone Scottish state to rule. Meanwhile the western isles are even more remote from the seat of Scottish power and vulnerable to foreign maritime powers. Since England could never conquer Scotland, its solution was to coopt the Scottish elite, who reciprocated, culminating in a merger of the two monarchies and then the two states in the seventeenth and eighteenth centuries. The British empire provided Scotland with peace, prosperity, and access to the rest of the world. History and geopolitics do not imply that Scottish independence is impossible, i.e. that union with the rest of Britain is inevitable and permanent. The Anglo-Scots union is only 314 or 418 years old, whereas Scotland existed as a recognizable kingdom for roughly six centuries prior to the joining of the crowns in 1603. It is entirely possible for Scotland to secede and break up the union known as Great Britain. The principle of rule by consent and modern democratic ideology make it difficult for London and Westminster to force Scotland into subjection like in the old days. In particular, American hegemony over Europe since WWII and the rise of the European Union have created a pathway for Scottish independence. England is no longer the indispensable gateway to peace and prosperity. Scotland can exist independently under the EU’s economic umbrella and the American security umbrella.   Europe has always played a major role in Scotland’s political fate and has always held the key to independence. Independence usually failed because European powers failed to devote large and steady resources to supporting Scotland militarily and economically. France was Scotland’s greatest patron and would lend its support for Scottish rebellion. But France also consistently failed Scotland (and Ireland) at critical junctures when independence might have been obtained. This is because France’s interests lay in distracting England rather than adopting Scotland. Chart 5Scottish Energy Production In Decline Today’s unified European continent could be a much greater patron than France ever was alone. The EU could assure Scotland of investment and access to markets even in the face of British resistance. However, the EU is still not politically unified: some members fear separatism in their own borders and therefore tend to oppose Scottish accession. It is possible that the EU could overcome this difficulty but only after a series of major events (on which more below). It took an American empire to clear the way for Irish independence. But Ireland has the moat of the Irish Sea – and the United Kingdom still retained Northern Ireland. Today the United States can be expected to keep its distance from quarrels within the UK or between the UK and EU. However, it does not have an interest in Scottish secession or any other disintegration of the UK, whether from a global security point of view (the West’s conflict with Russia) or even from the point of view of US grand strategy relative to Europe (prevention of a European empire that could challenge the US). An independent Scotland would struggle economically. Its declining base of fossil fuel reserves illustrates the problem of generating sufficient revenue to maintain the Scandinavian-style social welfare state that Scotland’s nationalists imagine (Chart 5). Scottish nationalists are keen to embrace renewable energy – and the Scottish Greens are pro-independence – yet Scotland is not a manufacturing powerhouse that will produce its own solar panels and windmills. In the face of economic difficulties, Scotland would become politically divided like it was for most of its history prior to union with England. England would revert to an obstructive or sabotaging role. It is telling that the Scottish voter turnout in the 2014 independence referendum was very strong – much stronger than in other recent elections and plebiscites, including the Brexit referendum in Scotland (Table 1). The implication is that it is much harder for Scotland to strike out on its own than it appears. Opinion polling cited above suggests that neither Brexit nor the COVID-19 pandemic has moved the needle decisively in the direction of independence. If anything it is the opposite. The Scottish National Party has lost momentum since 2014 and is losing momentum in advance of today’s local election, which has been pitched as the opportunity to make a second go at independence (Chart 6). Table 1Scotland: High Turnout In 2014 Independence Referendum Implies Firm Conclusion To Stay In UK Chart 6Scottish National Party Losing Momentum Just Ahead Of Holyrood Election Bottom Line: History suggests that the geopolitical and macroeconomic barriers to a unified and independent Scottish state are higher and stronger than they may appear at any given time, including the inevitable periods of tensions with England like today. The UK’s Saving Graces A fair question is whether the UK’s decision to leave the EU since 2016 has changed Scotland’s calculus. Brexit may also have affected the international context, reducing the EU’s willingness to intervene on the UK’s behalf and discourage Scottish ambitions. However, a handful of factors supports the continuation of the union despite Scotland’s grievances. The UK proved a boon amid COVID-19: While 62% of Scots voted against Brexit, the COVID-19 pandemic and recession have supplanted Brexit as the nation’s chief cause of concern. The UK and Scotland saw a higher rate of deaths during the biggest waves of the pandemic but now the pandemic is effectively over in the UK and Scotland, in stark contrast with the European Union (Chart 7). The UK has provided a net benefit to Scotland by inventing the vaccine and distributing it effectively (Chart 8). Scottish voters would have been worse off had they left the UK in 2014. Of course, Scottish nationalism is apparent in the fact that voters give the credit to Edinburgh while blaming London over its handling of the pandemic (Chart 9). But the underlying material reality – that being part of the UK provided a net benefit – will discourage independence sentiment. The Scottish Conservative Party and Labour Party are both in favor of sustaining the union and have benefited in opinion polling since the pandemic peaked. Chart 7COVID Deaths Collapse In ##br##United Kingdom Chart 8Scotland Benefited From UK Vaccine And Rollout   Chart 9Scots Praise Edinburgh, Blame London On COVID Handling Brexit is a cautionary economic tale: If Brexit is relevant to Scottish voters, it is not the source of grievance that it could have been. Prime Minister Boris Johnson achieved an exit and trade deal at the end of 2019-20 that largely preserves economic ties with the EU. True, the deal has problems that undermine the UK economy and enhance Scottish grievances. But these also serve as a warning to Scots who would attempt to exit the UK, highlighting the economic pitfalls of raising borders and barriers against one’s chief market. The UK’s trade is far more critical to Scotland’s economy than that of the EU (Chart 10).   Chart 10Major Constraint On Scottish Independence Unlike in the case of the UK and EU, Scotland shares the same currency and central bank with the UK. Scotland’s large banking sector stands to suffer drastically if the Bank of England ceases to be a lender of last resort. This would become a major problem at least until Scotland could be assured of admission into the EU and Euro Area. Otherwise redenomination into a national currency would deal an even greater financial and economic blow. Scots  would face a far more painful economic divorce from the UK than the UK faced with the EU. The UK’s fiscal blowout helped Scotland: Since the bank run at Northern Rock in 2007, the UK and Scotland have suffered a series of crises. This instability should discourage risk appetite today when contrasted with the possibility of stimulus-fueled economic recovery. In particular, the UK government is no longer pursuing fiscal austerity – an economic policy that fanned the flames of Scottish secession back in 2012. Indeed, the UK tops the ranks of global fiscal stimulus, according to the change in government net lending and borrowing as reported by the IMF. The UK’s outlier status ensures that Scotland receives more fiscal support than it otherwise would have (Chart 11). A brief comparison with comparable countries – Ireland, Belgium, France, Norway, Portugal – reinforces the point. Chart 11Scotland Benefited From UK Fiscal Blowout The UK’s aggressive policy of monetary and fiscal reflation is not a coincidence. It stems from the past two decades’ constitutional and political struggles – it is an outgrowth of domestic instability and populism. It includes an industrial policy, a green energy policy, and other rebuilding measures to combat the erosion of the state in the wake of hyper-globalization. Essentially the UK, even under a Tory government, is now about debt monetization and nation-building. While Scotland would have trouble bargaining for its share of EU resources, it benefits from the UK’s shift to government largesse and can use the threat of independence to receive greater funds from the United Kingdom. Geopolitics discourages a fledgling Scottish nation. Scotland hosts naval and air bases of considerable value to the UK, US, and broader NATO alliance. Former US President Trump’s punitive measures against the European allies and open doubts about the US’s commitment to NATO’s collective security illustrated the dangers of western divisions in the face of autocratic regimes like Russia and China. The US and EU are now recommitting to their economic and security bonds under the Biden administration. Scottish independence would undermine this recommitment and as such the small country would pit itself against the US, EU, and NATO. While the US and NATO would ultimately admit Scotland into collective security, for fear of cultivating a neutral Scotland that could eventually be exploited by Russia, they would likely discourage independence ahead of time to prevent a historic division within the UK and NATO. Chart 12No Urgency For A Second Referendum As for the EU, the Spanish government has indicated that it would be willing to make an exception for Scottish independence if it were negotiated amicably with the United Kingdom.2 Such statements are doubtful, however, as any successful secession would lend ideological credibility to Spanish secessionism – not only in Catalonia but also in the Basque country and elsewhere. And Spain is not the only country that harbors deep hesitations over Scottish accession to the European Union. Belgium, Slovakia, and Cyprus could also oppose it. It only takes a single veto to halt the whole accession process. Ultimately the EU could accept Scotland, just as would NATO, to avoid the dangers of having a neutral state in a strategic location. But the point is that Scottish voters cannot be certain. For example, Scotland cannot secure EU accession prior to leaving the UK and yet to leave the UK and fail to achieve EU accession would render it a fledgling. This explains why Scottish voters are not eager to hold a new independence referendum (Chart 12). Bottom Line: The UK offers medical, economic, fiscal, and geopolitical advantages to Scotland that independence would revoke. The context of Great Power struggle with Russia and China means that an independent Scotland would probably ultimately be admitted into NATO and the EU – but Scottish voters cannot be certain, a factor that discourages independence at least in the short and medium run. Scottish Hurdles Table 2 highlights the historic results of Scottish elections according to political party, popular vote share, and share of seats in parliament. Early, tentative signs suggest that the Scottish National Party maxed out in 2011. The party has suffered from a leadership schism, offshoot parties, and a distraction of its key message since 2014. The implication is not only that Scottish independence is on ice for now but also that the tumultuous constitutional disagreements are subsiding and voters want to focus on economic recovery. Table 2Scottish National Party Hit High-Water Mark In 2011? If the Scottish National Party manages to form a majority coalition capable of pushing forward a second referendum, it will face several hurdles. It will need a UK Supreme Court ruling on the legality of a referendum. If a referendum is declared legal (as it very likely will be), Scotland will need to forge an agreement with Prime Minister Boris Johnson to hold a referendum. If a referendum eventually is held and passes, an exit will need to be negotiated. In a post-Brexit world, investors cannot assume that any referendum will fail or that a referendum is a domestic political ploy that the ruling party has no serious intention of following through. Nevertheless it is true that the Scottish National Party could use the threat of a referendum to agree to negotiate a greater devolution of power from Westminster. The party could hold up England’s concessions as a victory while retaining the independence threat as leverage for a later date. Devolution in the past has strengthened the independence cause, as in the creation of the Scottish parliament in 1999. After all, a referendum loss would be devastating for the nationalists, whereas the threat of a referendum could yield victories without depriving the nationalists of their reason for being. It is notable that First Minister Nicola Sturgeon promised not to hold a “wildcat” referendum, in which Scotland holds a referendum regardless of what Westminster or the UK Supreme Court say. The implication is that Scottish nationalism is looking for a stable way to exit. But if stability is the hope then there is dubious support for independence in the first place. A wildcat referendum is theoretically still an option but a formal process with popular support is much more likely to result in a successful referendum than an informal process with dubious popular support. Chart 13Scotland’s Chronic Deficits If Scottish independence succeeded in any wildcat referendum, an extreme controversy would follow as Edinburgh tried to translate this result to the formal political and constitutional sphere. If the referendum were not recognized by the UK then Scotland would be forced to secede unilaterally at greater economic cost. Otherwise a third referendum (second formal referendum) would need to be held to confirm the results. Any third referendum would be irrevocable. As with Brexit, the secessionists would have to carry one or more subsequent elections to execute the political will in the event of secession. The point for investors is that volatility would be prolonged as was the case with Brexit. A major complication in Scottish independence remains the problem of public finances. Scotland’s fiscal standing is weak. Scotland ran a 9.4% of GDP budget deficit prior to COVID-19, excluding transfers from the UK, which compensates for a gap of about 6% of GDP (Chart 13).3 The country maintains generous social spending alongside a low-tax regime. There is no sign of correction as all Scottish parties are proposing more expansive social spending in the parliamentary election. The Scottish National Party is even proposing universal basic income. Scotland’s emergency COVID deficits are larger than the UK’s as well and projections over the coming years suggest that they will stay elevated. Historically economic growth keeps closely in line with the rest of the UK and there is no reason to believe independence would boost growth. The implication is that Scotland would have to curtail spending or raise taxes to come into line with UK-sized deficits, which are not small (Chart 14).4 Of course Scotland would not embrace austerity unless financial market pressure forced it to do so. Chart 14Scottish Deficit Projected Larger Than UK Scotland would become a high-debt economy. Its public debt-to-GDP ratio would be about 97%, on a back-of-the-envelope calculation. Back in 2013 estimates ranged around 80% of GDP.5 The Scottish National Party’s Sustainable Growth Commission projected in 2018 – before the pandemic blew an even wider hole in the budget deficit – that deficits would nearly have to be cut in half (i.e. capped at 5% of GDP and falling) to achieve a 50% debt-to-GDP ratio over 10 years.6 This is not going to happen. Scotland would also have to take on a portion of the UK’s national debt if it were to have an amicable divorce from the UK and retain the pound sterling. But then much of its newfound independence would be compromised from the beginning by legacy debt and monetary policy shackles. Similar restrictions would come with EU and euro membership. Any accession process after the pandemic would require conformity to the EU’s growth and stability pact, which limits deficits and debt. Redenomination into a national currency, as noted, would dilute domestic wealth, zap the financial industry, and self-impose austerity. Bottom Line: Even if the Scottish nationalists manage to put together a pro-independence majority in Edinburgh, they face a complex process in setting up a referendum. Its passage is doubtful based on the current evidence. But obviously in the wake of Brexit investors should not assume that a referendum attempt will fail or that a successful referendum will be thwarted by parliament after a “leave” vote. The timeline for a second referendum is not imminent – and Scottish independence is highly unlikely, albeit possible at some future date given that middle-aged Scots lean in favor of independence.   Investment Takeaways We will conclude with two market takeaways: Chart 15UK Stocks Recovering From Referendum Fever Chart 16Hindsight On How To Play A Constitutional Struggle The UK’s referendum fever has compounded political uncertainty and contributed to negative factors for the UK equity market over the past decade. A segmentation of the FTSE 100 according to country shows that Scottish-based companies’ share prices rolled over in the aftermath of the 2014 referendum, while the non-Scottish segment performed better (Chart 15). The implication is not that the referendum caused stocks to fall but that the 2014 independence push was the result of national exuberance supercharged by high commodity prices. Enthusiasm for independence has been flat since that time. What is clear is that financial markets look even less favorably upon Scottish equities than other British equities – another sign of the economic problems that will ultimately discourage Scottish voters from going it alone. In advance of the Scottish election, we went tactically long the Swiss franc relative to the British pound to capitalize on jitters that we expected to hit the currency. This trade was in keeping with the long fall of GBP-CHF over the past decade (Chart 16). But the stronger forces of global stimulus, vaccination, economic normalization, and recovery will soon provide a tailwind for sterling yet again. Therefore we are booking 1% gains and shifting to a more optimistic outlook on the pound. With the Brexit saga and the COVID crisis in the rear view mirror, and the tail risk of Scottish independence unlikely, the pound can resume its upward trajectory – at least relative to the Swiss franc. International equities and cyclicals are also poised to continue rising as the world recovers. We recommend investors go long the FTSE 100 relative to developed markets excluding the United States. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Jeremy Black, “The Legacy of the Scottish Referendum,” Foreign Policy Research Institute E-Notes, September 22, 2014, fpri.org. 2 See Akash Paun et al, "Scottish Independence: EU Membership And The Anglo-Scottish Border," Institute For Government, March 2021, instituteforgovernment.org.uk. 3 See Eve Hepburn, Michael Keating, and Nicola McEwen, "Scotland’s New Choice: Independence After Brexit," Centre on Constitutional Change, 2021, centreonconstitutionalchange.ac.uk. 4 See David Phillips, "Updated projections of Scotland’s fiscal position – and their implications," Institute for Fiscal Studies, April 29, 2021, ifs.org.uk. 5 Granting that the UK’s general government gross debt stood at GBP 1.88 trillion at the end of 2020, and assuming that Scotland takes on a share of this debt equivalent to Scotland’s share of the UK’s total population and output (roughly 8%), the Scottish debt would stand at GBP 150 billion out of a Scottish GDP at current market prices of GBP 156 billion, or 97% of GDP. For the 2013 estimate of at least 80% of GDP, see David Bell, "Scottish Independence: Debt And Assets," Centre on Constitutional Change, December 3, 2013, centreonconstitutionalchange.ac.uk.  6 Scottish National Party, "Part B: The Framework & Strategy for the Sustainable Public Finances of an Independent Scotland," Sustainable Growth Commission, May 2018, sustainablegrowthcommission.scot. The commission’s debt curbs will have to be revised in the wake of COVID-19. For discussion see Chris Giles and Murie Dickie, "Independent Scotland would face a large hole in its public finances," Financial Times, April 2, 2021, ft.com.  

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 Chart 9   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades