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Highlights A rise in global bond yields has rarely been a reliable precursor of a stronger dollar. This is because the dollar reacts to interest-rate differentials, rather than the level of global yields. Changes in the dollar correlate with both the level and the rate of change in relative yields. A definitive shift to a bullish dollar stance will require a rise in relative US real rates in the order of 50-to-75 bps. Meanwhile, negative/low interest rates could have caused a swing in the currency/yield correlation, especially at the short end of the curve. In aggregate, the dollar responds to relative rates of return. This includes not only fixed income flows, but equity flows as well. As such, the US equity market also needs to outperform foreign bourses to make the case for a stronger dollar. The dollar is oversold and remains ripe for a countertrend bounce. This noise could be confused for a durable bullish signal. Feature Chart I-1No Rise In Real Yields Global bond yields are on the rise, driven by the long end of the curve. This has included US yields, where the 10-year rate has bounced from a low of 36 bps last March to 130 bps today. Rising yields have important ramifications for equity prices (through the discount rate) and exchange rates. A rise in yields can be driven by prospects of either better growth, higher inflation expectations, or a combination of the two. This could bring forward expectations that the central bank will tighten monetary policy faster. In the case of the US and Eurozone, the culprit behind higher yields has been higher inflation expectations (Chart I-1). What does this mean for exchange rates? Are rising yields positive or negative for the dollar? Also, does it matter which component is driving yields higher – growth or inflation expectations? Finally, which currencies have historically benefited the most from an uptick in global yields?     Correlation Between Yields And Exchange Rates Chart I-2Bond Yields And Currencies Often Diverge The historical evidence is that there is little correlation between the dollar and the level or direction of global bond yields. Since the end of the Bretton Woods system in the 1970s, the trade-weighted dollar has appreciated while global bond yields have collapsed (Chart I-2). More important has been the path of relative interest rates. For example, the ebb and flow of EUR/USD has tracked the yield differential between Bund and Treasury yields since the 1970s (bottom panel Chart I-2). Currencies react more to the path of relative real rates than nominal rates. In theory, rising inflation is negative for a currency since its purchasing power is reduced. In a globally competitive system, the currency adjusts lower to equalize prices across borders. However, rising growth expectations allow policy rates to catch up with a higher neutral rate. This improves the relative rate of return for bond investors, allowing for capital inflows. Across the G10, there has been a longstanding relationship between real interest rate differentials and the path of the currency (Chart I-3A and Chart I-3B). Chart I-3ACurrencies Move With Relative Real Rates Chart I-3BCurrencies Move With Relative Real Rates Importantly, US real rates have not risen much against the rest of the world with the latest uptick in global bond yields. In fact, compared to countries such as Australia, the UK, Switzerland, and New Zealand, they have declined. This is negative for the dollar on the margin. While the direction of relative real rates is important, the absolute level of real yield spreads also matters for currency and bond investors. Chart I-4 shows that the dollar tends to respond to the level of real rates in the US, compared to the rest of the world. When US real rate differentials are positive, the dollar tends to appreciate on a year-over-year basis. Looking at a snapshot of global real yields, the US sits below the median (Chart I-5). Commodity-producing countries fare much better. So do Japan and Switzerland. Based on the historical precedent, US real rates will have to improve by about 50-to-100 bps to set the dollar up for structural upside. Chart I-4US Real Rates Are ##br##Still Low Chart I-5US Real Rates Need 50-75 Bps Upside To Make Them Attractive Bonds Versus Equities There are multiple drivers of exchange rates. Bond yields are just one of them. Equity flows also matter. One way to square the circle on whether the level of US real rates makes a difference for the dollar is through flow data. Foreign inflows into US Treasuries remain negative. This suggests that despite the rise in US nominal rates since March of last year, foreign investors are still not convinced they are sufficiently high to compensate for the rising US twin deficits. Rather, inflows into equities have been rather strong. This raises the prospect that the equity market has become an important driver of currency returns and will become the dominant driver going forward (Chart I-6). Importantly, the correlation between bond yields and exchange rates at very low rates is not straightforward. Bond investors span the duration spectrum, and 1-year, 2-year and even 5-year yield differentials are not meaningfully different across countries (Chart I-7). This is particularly the case if hedging costs are taken into consideration. It explains why currencies have not moved much in light of the violent moves at the long end of the yield curve, as shown in Chart I-3A and Chart I-3B. At times, the moves have been opposite to what economic theory would suggest. Chart I-6Foreign Investors Like US Equities, ##br##Not Bonds Chart I-7A Regime Shift For Interest Rates And Currencies? Chart I-8The CAD Is Not Driven By Relative Interest Rates, But Terms Of Trade If a central bank explicitly targets a bond yield, that makes it difficult for that same yield to send a reliable signal about the economy. That is why at very low rates, markets start to gravitate to other indicators of growth. These include, but are not limited to, differences in PMI surveys or even commodity prices. For example, the performance of the Canadian dollar can be perfectly explained by the rise in Canadian terms of trade, even though real interest rate differentials between Canada and the US have not done much (Chart I-8). Rising oil prices are usually bullish for Canadian national income, on a relative basis. They are also bullish for Canadian equities that are more resource based. Inflows into these sectors tend to be positive for the currency. In the case of Europe, the euro has rolled over on the drop in relative real rates, but the gap in economic data surprises with the US has provided a far better explanation of euro underperformance in recent weeks. With domestic European economies in various lockdowns, economic data is becoming relatively weaker (Chart I-9). This is curbing growth, inflation, and interest rate expectations. Chart I-9Economic Divergences Explain EUR/USD, Rather Than Real Interest Rates This brings up a bigger point. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when cyclical versus defensive style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Higher yields tend to be beneficial for cyclical stocks, especially banks. In the case of Europe, the bourses are heavily weighted toward banks, industrials, and consumer discretionary sectors. Not only do these sectors need to do well for the equity market to outperform, they are also strongly tied to the performance of the domestic economy. That is why for the most part, both equity and currency relative performances tend to be in sync (Chart I-10). The bottom line is, to get the USD call right, investors should broaden their scope from relative bond yields to other drivers of currency returns. With most developed market interest rates near zero at the short end, relative bond yields matter less. More importantly, flows will be dictated by investors’ perceptions of where to find higher relative rates of return. This, in turn, will be based on relative growth fundamentals. Our bias is as follows: The US equity market has become very tech-heavy. Rising interest rates tend to hurt higher duration sectors such as tech and health care. At the margin, this hurts the relative performance of US equities. As such, rising rates will negatively impact the US equity market more, and will not derail our bearish dollar view (Chart I-11). Chart I-10The Dollar And Relative Stock Markets Chart I-11Global Defensives And Interest Rates The Signal And The Noise Chart I-12The Dollar Could Be Seasonally Strong There are a few conclusions from the insights made above. First, US real interest rates have not meaningfully improved relative to the rest of the world. Second, a rise in US real rates of 50bps above the rest of the world would be required in order to seriously question our bearish dollar view, from a fixed income angle. Finally, sector performance matters a great deal, which means that the current rise in global bond yields is bearish for US stocks compared to non-US bourses. This places the US dollar at a very critical juncture. On the one hand, the dollar is still very oversold. Every time the dollar bounces from these oversold levels, the bulls rage forward, taking it as vindication that the uptrend has resumed. As we have highlighted, the DXY could hit 94 before working off oversold conditions. February and March tend to be excellent months for a rise in the DXY (Chart I-12). On the other hand, a rise in the dollar could be genuine confirmation that the US is leading the recovery both in terms of rates and equity performance. Weakness in the euro will not be particularly surprising, given the lopsided level of optimism. We remain bullish until the euro hits 1.35. The reality is that no one knows the trajectory of global growth in 2021, let alone how the relative growth profile between countries will play out. The euro area is heavily levered to global growth, hence we remain bullish EUR/USD. However, this view will change if the facts change. Meanwhile, in a higher inflationary environment, the outperformers tend to be the Norwegian krone and commodity currencies. This makes sense since commodity prices (and ultimately producer prices) tend to outperform in a period of rising inflation. It dovetails nicely with our high-conviction view to heavily overweight the Scandinavian currencies (Chart I-13). Chart I-13Rising Inflation Is Bullish For The NOK   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been rather robust: Inflation expectations are well anchored. The February 5-10 year survey from the University of Michigan pinned inflation expectations at 2.7% year-on-year. Core PPI came in at 2% year-on-year in January, blowing out expectations of a 1.1% rise. Retail sales galloped above expectations. The control group printed 6% month-on-month in January compared to expectations of a 1% rise. Housing starts declined month-on-month in January, but building permits rose so it’s a wash if rising rates are affecting cyclical spending in the US.     The DXY index rose by around 30 bps this week. There is a clear tug-of-war in markets, with the Fed signaling that policy will remain easy as far as the eye can see, but bond markets pushing up longer-term rates. Our bias is that any pickup in inflation will prove transitory, vindicating Fed policy in 2021.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: The trade surplus widened to €27.5 billion in December. 4Q GDP slowed by 5% year-on-year, in line with expectations. The ZEW survey was a very positive surprise. The expectations component for February jumped from 58.3 to 69.6. The euro fell by 0.4% against the US dollar this week. The markets will keep oscillating between how deep the euro area slowdown will be for now, and the magnitude of any potential rebound.  We are bullish on euro area growth, especially given tentative signs of a revival in animal spirits (proxied by the expectations component of the surveys). Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been positive: 4Q GDP surprised to the upside, rising an annualized 12.7% quarter-on-quarter. Exports are booming, rising 6.4% year-on-year in December. The rise in machinery orders by 11.8% in December corroborated the positive contribution from CAPEX to GDP. The Japanese yen fell by 0.9% against the US dollar this week. As Japanese data surprised to the upside, inflation expectations also rose and depressed real rates. The drop in the yen signals the market might be pricing in that the BoJ will not fight strength in economic data with more tapering. We are long the yen as a portfolio hedge, but that view has been shaken by recent weakness. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: 4Q GDP in the UK was slightly better than expected at 1% quarter-on-quarter. Core CPI for January came in at 1.4%, in line with expectations. House prices are soaring, rising 8.5% in December on a year-on-year basis. The pound was the best performing currency this week, rising about 1%. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. We are tightening stops this week to protect profits.  Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The most important data this week from Australia was the employment report: There were 29.1K new jobs in January, in line with expectations. More importantly, there were 59K new full-time jobs, while part-time jobs fell by 29.8K. The unemployment rate declined from 6.6% to 6.4%. The Aussie was flat this week. When it comes to Covid-19, Australia ranks extremely well on a global scale. The number of new cases are low, the government has secured enough vaccines for the entire population and economic activity has rebounded given very close ties to China. We like the AUD, and are long versus the NZD. However, we expect that any positive surprises in the rest of the world will hurt AUD relative to the Americas. As such, we are short AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Net migration remained at a very low level of 415 individuals in December. The New Zealand dollar fell by 0.3% against the US dollar this week. The kiwi has catapulted itself to the most expensive currency in our PPP models. According to our attractiveness ranking, it is also the worst. We are already long AUD/NZD but are looking for more opportunities to short the kiwi at the crosses. Stay tuned.  Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: Housing starts rose by 282.4K, well above expectations for a January level of 228.3 K. Foreigners continued to by C$5 billion of securities in December. CPI was in line with expectations. The core median came in at 1.4% but the core trim was 1.8%, a nudge below the BoC range of 1-3%. The Canadian dollar was flat against the US dollar this week. The path of the CAD will be dictated by two factors – 1) relative economic growth between the US and the rest of the world (CAD benefits more from better US growth); and 2) the path of commodity prices, especially oil. Both remain positive for the CAD, as we alluded to last week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been flat: Core CPI came in at 0% in January, suggesting Switzerland has tentatively exited deflation (the print was -0.4% in December). January exports rebounded, even as watch sales remained quite weak. The Swiss franc fell by 0.7% against the US dollar this week. Safe-haven currencies were laggards, with only the Swiss franc lagging the Japanese yen. This is clearly a signal that the market remains very much in risk-on mode. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: 4Q mainland GDP came in at 1.9% quarter-on-quarter. Expectations were for a 1.3% rise. The trade balance exploded to NOK 23.1 billion in January. The Norwegian krone was flat against the US dollar this week, but outperformed the euro. The NOK is the perfect example of a currency on a coiled spring – cheap valuations, a liquidity discount, and primed to benefit from the global economic rebound. We are long the NOK against the euro, loonie, and USD. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The most important data from Sweden this week was the CPI: The headline measure for January came in at 1.6%, in line with expectations. The core measure at 1.8% was also in line with expectations. The Swedish krona was flat against the US dollar this week. The Swedish COVID-19 experiment is coming home to roost. On the one hand, much higher cases compared to Norway have dampened economic activity as people voluntarily try to avoid infection. Sweden chose to keep its economy largely open. On the other hand, Sweden is a highly levered play on the global cycle. We think the latter will dominate, and so are positive on the krona. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights US inflation is set to increase sharply over the coming months as base effects kick in. Higher fuel prices, fiscal stimulus, and the partial relaxation of lockdown measures should also boost inflation. The Fed is unlikely to react hawkishly to higher inflation, arguing that it is largely transitory in nature. While the Fed’s relaxed attitude towards inflation risks may be justified in the near term, there is a high probability that inflation will get out of hand later this decade. Contrary to conventional wisdom, many of the factors that led to high inflation in the 1970s could reassert themselves. Investors should overweight stocks for now, but be prepared to reduce equity exposure in about two years. US Inflation Has Bottomed US inflation surprised on the downside in January. The core CPI was flat on the month, compared with the consensus estimate for an increase of 0.2%. We expect US inflation to move higher over the coming months. The weakness in January’s inflation print was concentrated in sectors of the economy that have been hard hit by the pandemic. Airline fares dropped 3.2%, hotel rates fell 1.9%, and entertainment admission prices declined 5.5%. Prices in these sectors should rise on a year-over-year basis as base effects kick in (Chart 1). The relaxation of lockdown measures should also help to partially restore demand in these areas. WTI crude prices have risen 70% since the end of October. Rising energy prices should push up headline inflation, with some bleed-through to core prices. Chart 2 shows that there is a strong correlation between gasoline prices and headline inflation. If gasoline prices evolve in line with what is predicted by the futures market, headline inflation could temporarily rise to 4% this spring. Chart 1Base Effects Will Push Inflation Higher Chart 2Strong Link Between Gasoline Prices And Headline Inflation   In addition, the lagged effects from a weaker dollar should translate into higher goods prices in the US (Chart 3). A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation (Chart 4).  Chart 3A Weaker Dollar Will Be A Tailwind For Inflation Chart 4Stronger Labor Market Will Boost Housing Inflation Fiscal stimulus should further supercharge demand, adding to inflationary pressures. Ironically, Republican unwillingness to offer modest, politically palatable cuts to President Biden’s proposed aid bill has opened the door to the Democrats ramming through the entire $1.9 trillion package via the reconciliation process. As we discussed last week, the amount of stimulus in the pipeline easily dwarfs the size of the output gap.   From Reflation To Inflation? Deflation is bad for stocks, just as is high and accelerating inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. Chart 5Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed We are currently in a reflationary Goldilocks zone, where inflation expectations have risen but not by enough to force the Fed’s hand. There is a high probability we will stay in this Goldilocks zone for the remainder of the year. The 5-year/5-year forward TIPS breakeven rate is still below the level that the Fed regards as consistent with its long-term inflation objective, and even farther below the level that would cause the Fed to panic (Chart 5). Jay Powell told The Economic Club of New York last week that the Fed is unlikely to “even think about withdrawing policy support” anytime soon. The Fed minutes released on Wednesday echoed this view. That ‘70s Show? The path to higher interest rates is lined with lower interest rates. A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened during the 1970s, it is prudent to ask whether something like that could happen again. Investors certainly do not believe a replay of the 70s is in the cards, at least if long-term CPI swaps are any guide (Chart 6). Yet, we think that a 1970s-style inflationary episode is a greater risk than most investors realize. As we discuss below, much of what investors believe about how inflation emerged during that period is either based on myths, or at best, half-truths. Let’s examine each of these misconceptions in turn. Myth #1: High inflation in the 1970s was primarily driven by supply disruptions, with oil shocks being the most prominent. Fact: Oil shocks exacerbated the inflation problem in the 1970s, but it was an overheated economy that permitted inflation to rise in the first place. Inflation took off in 1966, seven years before the first oil shock. By 1969, core CPI inflation was running at close to 6% (Chart 7). Chart 6Investors Do Not Expect Inflation To Vault Higher Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s   Similar to today, fiscal policy was exceptionally accommodative in the mid-1960s. The escalation of the Vietnam War produced a surge in military expenditures. Social spending rose dramatically with the introduction of Lyndon Johnson’s “Great Society” programs. Medicare and Medicaid took effect in July 1966. Amy Finkelstein has estimated that Medicare, the larger of the two health care programs, led to a 37% increase in real hospital expenditures between 1965 and 1970. Johnson’s “guns and butter” policies caused government spending to surge in the second half of the decade. The budget deficit, which was broadly balanced during the first half of the 60s, swelled to 4% of GDP (Chart 8). As fiscal policy was loosened, the economy began to overheat. The unemployment rate fell to 3.8% in 1966, two percentage points below what economists later concluded had been its full-employment level. Chart 8US "Guns And Butter" Policies In The 1960s Caused Government Spending To Swell Myth #2: The Phillips curve is much flatter today. Chart 9The Increase In Inflation In 1966 Was Broad-Based Fact: The Phillips curve was also flat during the 1960s. Core inflation was remarkably stable during the first half of the 60s, averaging about 1.5%, even as the unemployment rate steadily declined. Then, starting in 1966, core inflation more than doubled within the span of ten months. As Chart 9 illustrates, the sudden spike in inflation in 1966 was fairly broad-based. A “kink” in the Phillips curve had been reached. That the relationship between inflation and unemployment turned out to be non-linear is not surprising. As long as there is some slack in the labor market, employers are likely to resist raising wages. Thus, a decline in unemployment from a high level to a merely moderate level is unlikely to lead to meaningful wage inflation. It takes a truly overheated labor market – one that forces firms to engage in a tit-for-tat battle to entice workers – for the relationship between unemployment and inflation to reassert itself. In the near term, there is little risk that the US economy will reach a kink in the Phillips curve. Jason Furman estimates that the unemployment rate stood at 8.3% in January if one adjusts for the drop in labor force participation and methodological problems with how the BLS defines temporarily furloughed workers. This is well above the level that could trigger a price-wage spiral. Chart 10Is The Phillips Curve Really Dead? Yet, it would be naïve to think that such a spiral could not materialize in a few years. As Chart 10 shows, over the past 40 years, every time the US labor market was on the cusp of overheating, something would invariably come along to push up unemployment. Last year, it was the pandemic. In 2008, it was the Global Financial Crisis. In 2000, it was the dotcom bust. In the early 1990s, it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a truly exogenous shock. The preceding three recessions were fomented by growing economic imbalances, which were ultimately laid bare by a Fed hiking cycle. One can debate the degree to which the US economy is suffering from non-pandemic related imbalances today, but one thing is certain: The Fed is not keen on raising rates anytime soon. Thus, whatever imbalances exist today may not be exposed before the economy has had the chance to overheat. Myth #3: Inflation expectations are better anchored these days. Chart 11Long-Term Bond Yields Lagged Inflation During The 1960s Fact: Inflation expectations certainly became unmoored in the 1970s. However, there is not much evidence that expectations were adrift prior to the sudden increase in inflation in 1966. At the time, the US had not experienced a major episode of inflation since the Civil War. While long-term bond yields did rise in the second half of the 60s, they generally lagged inflation, suggesting that investors were caught off-guard (Chart 11). It should also be noted that the US and other major economies operated under the Bretton Woods system of fixed exchange rates during the 1960s. Each US dollar was convertible into gold at the official rate of $35 per ounce. The existence of this quasi-gold standard helped anchor inflation expectations. The system began to fall apart in the late 1960s as inflation rose. When President Nixon suspended the dollar’s convertibility into gold in August 1971, the US CPI had already increased by nearly 30% from its 1965 level. While the collapse of the Bretton Woods system in the early 1970s undoubtedly caused inflation expectations to become further unhinged, the breakdown of the system would not have occurred if inflation had not risen in the first place. Myth #4: Widespread wage indexation and powerful trade unions fueled an acceleration in the 1960s. Fact: Just as was the case with the unmooring of inflation expectations, wage indexation was more a response to rising inflation than a cause of it. Chart 12 shows that the share of workers covered by cost of living adjustments only jumped after inflation had accelerated. Chart 12Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around As far as unions are concerned, the US unionization rate peaked by the end of the 1950s and was already on a downward path when inflation began to rise. Revealingly, Canada experienced a similar decline in inflation as the US in the early 1980s even though unionization rates remained elevated (Chart 13). This suggests that union power was not a dominant driver of inflation. Chart 13Inflation Fell In Canada, Despite A High Unionization Rate   Myth #5: Today’s globalized economy will limit inflationary pressures. Fact: The empirical evidence generally suggests that the impact of globalization on US inflation has been smaller than widely supposed.1 This is not surprising. The US is a fairly closed economy. Imports account for only 15% of GDP. As a result, a fairly large change in relative prices is necessary to prompt Americans to shift a meaningful fraction of their expenditures towards foreign-made goods. Such a shift in spending would require a real appreciation of the US dollar. A real appreciation could occur either if US inflation exceeds inflation abroad or if the nominal value of the dollar strengthens against other currencies. (Admittedly, the standard terminology can be a bit confusing; just think of a real US dollar appreciation as anything that makes the US economy less competitive). Here’s the thing though: The US dollar is unlikely to strengthen unless the Federal Reserve starts to sound more hawkish. If the Fed remains in the dovish camp, real rates could fall as inflation edges higher. This will put downward pressure on the dollar, leading to a smaller trade deficit and even more aggregate demand.  Myth #6: Demographics are much more deflationary now than they were in the past. Fact: Demographic trends arguably did help push down inflation over the past few decades. However, population aging is likely to boost inflation going forward. Chart 14 shows that the ratio of workers-to-consumers in the US and around the world – the so-called “support ratio” – rose steadily in the 1980s, 1990s, and 2000s as more women entered the labor force and the number of dependent children per household declined. An increase in the ratio of workers-to-consumers is equivalent to an increase in the ratio of production-to-consumption. A rising support ratio is thus deflationary. More recently, however, the support ratio has begun to decline as baby boomers retire but continue to spend. Consumption actually increases in old age once health care spending is included in the tally (Chart 15). As production falls in relation to consumption, inflation could rise. Chart 14Support Ratios Are Declining Globally After Rising Steadily For Three Decades Chart 15Consumption Increases In Old Age Once Health Care Spending Is Factored In   Myth #7: Today’s fast pace of technological innovation will keep inflation down. Chart 16Total Factor Productivity Growth Is Lower Than It Was During The Great Inflation Fact: Total factor productivity growth – a broad measure of innovation – is not just low by historic standards today; it is lower than during the period of the Great Inflation spanning from 1966 to 1982 (Chart 16). Some have argued that productivity growth is mismeasured. We have examined this argument in the past and found it wanting. In any case, economic theory does not necessarily say that technological innovation should be deflationary. Economic theory states that faster innovation should lead to higher real incomes. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Myth #8: Policymakers have learned from their mistakes. It is easy to dismiss this claim, but it is worth considering it seriously. Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies (Chart 17). They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand. Chart 17Central Banks Overestimated The Degree Of Slack In Their Economies During The Great Inflation Is it possible that economic analysis has improved so much over the past 40 years that such mistakes would not be repeated today? Perhaps, but it is worth noting that not only did most economists fail to predict the productivity boom in the late 1990s, most were not even aware that it had happened until after it had ended. Knowing what is happening to the economy in real time is hard enough. Predicting what will happen to such things as trend growth and the natural rate of unemployment is even more difficult. Myth #9: The Fed is a lot more independent now. Fact: We will only know for sure when this independence is tested. History clearly shows that inflation tends to be higher in countries which lack independent central banks (Chart 18). The Fed’s independence was compromised in the 1970s. In his exhaustive study of the Nixon tapes, Burton Abrams documented how Richard Nixon sought, and Fed Chairman Arthur Burns obligingly delivered, an expansionary monetary policy in the lead-up to the 1972 election. Chart 18Inflation Is Higher In Countries Lacking Independent Central Banks Starting with the appointment of Paul Volcker, the Fed sought to regain its independence. Most recently, Jay Powell publicly resisted Donald Trump’s efforts to prod the Fed to ease monetary policy. Yet, the Fed’s independence may turn out to be illusory. The Fed wasted little time in slashing rates and relaunching its QE program once the pandemic began. But will it be as quick to tighten monetary policy if inflation starts getting out of hand? Jay Powell’s four-year term as chair runs through February 2022. He will need to stay in Joe Biden’s good graces if he hopes to be reappointed to a second term. The fact that government debt levels are so high further complicates matters. Higher interest rates would force the government to shift funds from social programs towards bond holders. Will the Fed raise rates even if it faces strong political opposition? Time will tell. Investment Conclusions Chart 19Social Unrest Can Fuel Inflation While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and the present day. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: Just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy. The 1960s was a decade of rising political and social unrest. Crime rates went through the roof, a trend that was eerily matched by rising inflation rates (Chart 19). Early estimates suggest that the US homicide rate jumped by 37% in 2020 – easily the largest one-year increase on record. As was the case in the 1960s, most of the news media has ignored this disturbing development. What should investors do? Our tactical MacroQuant model is flagging some near-term risks for stocks. Nevertheless, as long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors with a 12-month horizon to bail on equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Commodity producers are a natural choice. Banks could also gain from an uptick in inflation. Chart 20 shows the remarkably strong correlation between the performance of US banks relative to the S&P 500 and the 10-year Treasury yield. Higher bond yields would boost bank net interest margins, leading to higher profits. Banks are also very cheap and have started to see their earnings estimates rise faster not only relative to the broader market but even relative to tech stocks (Chart 21). Chart 20Bank Shares Are A Buy (I) Fixed-income investors should keep duration risk low. They should also favor inflation-protected securities over nominal bonds. Chart 21Bank Shares Are A Buy (II) Looking further out, the secular bull market in stocks will end when inflation rises to a high enough level that even the Fed cannot ignore. That day will arrive, but probably not for another two years.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1  Globalization is often cited as a potential reason behind low inflation in advanced economies, including the US. However, a number of empirical studies have found that globalization did not play a major role. In general, domestic economic conditions are seen as the main factor in the inflation process. Please see Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, “Some Simple Tests of the Globalization and Inflation Hypothesis,” Board of Governors of the Federal Reserve System (International Finance Discussion Papers No. 891) (April 2007); Laurence M. Ball, “Has Globalization Changed Inflation?” National Bureau of Economic Research Working Paper Series 12687 (November 2006), and associated blog post “Has Globalization Changed Inflation?” National Bureau of Economic Research,  (June 2007); Janet. L. Yellen, 'Panel discussion of William R. White “Globalisation and the Determinants of Domestic Inflation”,' Presentation to the Banque de France International Symposium on Globalisation, Inflation and Monetary Policy (March 2008); Fabio Milani, “Global Slack And Domestic Inflation Rates: A Structural Investigation For G-7 Countries,” Journal of Macroeconomics, (32:4) (2010); and and Lei Lv, Zhixin Liu, and Yingying Xu, “Technological progress, globalization and low-inflation: Evidence from the United States,” PLoS ONE, (14:4), (April 2019).   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights Both the US and Iran have the intention and capability of restoring the 2015 nuclear deal so investors should presume that an escalation in tensions will conclude with a new arrangement by August this year. However, the deal that the Iranians will offer, and that Biden can accept, may be unacceptable to the Israeli government, depending on Israel’s March 23 election. Moreover if a deal is not clinched by August, the timeframe will stretch out for most of Biden’s term and strategic tensions will escalate. Major Middle Eastern conflicts and crises tend to occur at the top of the business cycle when commodity prices are soaring rather than in the early stages where we stand today. But regional instability is possible regardless, especially if the US-Iran talks fall apart. Maintain gold and safe-haven assets as the Iranian question can lead to near-term escalation even if a deal is the end-game. Feature Geopolitics is far from investors’ concerns today, so it could create some nasty surprises. Two urgent tests await the Biden administration – China/Taiwan and Iran – and provide a basis for investors to add some safe-haven assets and hedges amidst an exuberant stock rally in which complacency is very high. The past week’s developments underscore these two tests. First, Chinese officials flagged that they would cut off rare earth elements to the US, implying that they would retaliate if Biden refuses to issue waivers for US export controls on semiconductors to China.1 Second, Biden spoke on the phone with Benjamin Netanyahu for the first time. The delay signaled Biden’s distance from Netanyahu and intention to normalize ties with Israel’s arch-enemy Iran. In both the Taiwan Strait and the Persian Gulf, the base case is not a full-fledged military conflict in the short run. This is positive for the bull market. But major incidents short of war are likely in the near term and major wars cannot be ruled out. In this report we update our view of the Iran risk. A long-term solution to the nuclear threat is not at hand, which means that Israel could in the worst-case take military action on its own. Meanwhile tensions and attacks will escalate until a deal is agreed. Iranian-backed forces in Iraq have already attacked a US base near Erbil, killing an American military contractor.2 In the event of an Iranian diplomatic crisis, the stock market selloff will be short. The macro backdrop is highly reflationary and investors will buy on the dips. In the event of full-scale war, the US dollar will suffer for a longer period. Oil Price A Boon But Middle East Regimes Still Vulnerable Chart 1Oil Recovery A Boon For Middle East Markets Brent crude oil prices have rebounded to $65 per barrel on the global economic recovery. Middle Eastern equities are rallying in absolute terms, though not relative to other emerging markets (Chart 1). This underperformance is fitting given that the region suffers from poor governance, obstacles to doing business, resource dependency, insufficient technology and capital, and high levels of political and geopolitical risk. Non-oil producers and non-oil sectors in the Middle East have generally lagged the global economic recovery (Chart 2). The continuation of the recovery is essential to these regimes because most of them lack the fiscal room to provide large fiscal relief packages. The global average in fiscal support over the past year has been 7.4% but most Middle Eastern governments have provided 2% or less (Chart 3). Current account deficits have plagued oil producers since the commodity bust of 2014 and twin deficits have become a feature of the region, limiting the fiscal response to the global pandemic. Chart 2Middle East Economy Starts To Recover Chart 3Middle Eastern Regimes Fiscally Constrained The good news is that the recovery is likely to continue on the back of vaccines and fiscal pump-priming in all of the major economies. The bad news is that a black cloud hangs over the Middle East in the form of geopolitics. Given the underperformance of regional equities, global investors are not ignoring these risks – but they are a persistent factor until the Biden administration survives its initial tests in the region to create a new equilibrium. The unfinished geopolitical business in the region centers on the role of the US and the question of Iran. It is widely understood that the US has less and less interest in the region due to its newfound energy independence on the back of the shale revolution (Chart 4). This is why the US can afford to sign and break deals as it pleases under different administrations, namely the 2015 Iranian nuclear deal, otherwise known as the Joint Comprehensive Plan of Action (JCPA). The Obama administration spent two terms concluding the deal while the Trump administration spent one term nullifying it, leaving the central geopolitical question of the region in limbo. Israel and Arab governments feel increasingly insecure in light of the US’s apparent lack of foreign policy coherence and declining interest in the region. The US has not truly abandoned the region – if anything the Biden administration is looking to maintain or increase US international involvement.3 Washington still sees the need to preserve a strategic balance between Iran and the Arab states, prevent Iran from gaining nuclear weapons, and maintain security in the critical oil chokepoint of the Persian Gulf and Strait of Hormuz (Chart 5). But Washington’s appetite for commitment and sacrifice is obviously waning. The American public is openly hostile to the idea of Middle Eastern entanglements, and three presidents in a row have been elected on the assurance that they would scale down America’s “forever wars.” A decisive majority of Americans, including military veterans and Republicans, believe the wars in Afghanistan and Iraq were not worth fighting.4 And only 6% of Americans view Iran as the top threat to their country. Chart 4Waning US Interest In Middle East Chart 5Strait Of Hormuz Critical To Global Stability America’s lack of concern about the Iranian threat marks a difference from the early 2000s and especially from its critical Middle Eastern ally Israel. Naturally Israelis have a much greater fear of Iran, and 58% see it as the nation’s top threat (Chart 6). Israel and the Gulf Arab states are drawing together, under the framework of the Trump administration’s Abraham Accords, in case the US abandons the region. A deal normalizing relations with Iran would enable Iran to expand its power and influence and, if unchecked by the US, would pose a long-lasting threat to US allies. Chart 6No US Appetite For War With Iran – Israel A Different Story Chart 7China/Asia, Not Iran, The Strategic Priority For The US The US’s reason for dealing with Iran is that it needs to devote more attention to its strategy in the western Pacific in countering China (Chart 7). But China is also a reason for the US to stay involved in the Middle East. China’s role is expanding because of resource dependency and the desire to expand economic integration. Beijing wants to deepen its global investments, open up new markets, and create closer links with Europe (Chart 8). Chart 8AChina's Expanding Role In Middle East Chart 8BChina's Expanding Role In Middle East Chart 9Unresolved US-Iran Deal A Geopolitical Risk The opening of the Iranian economy would give the US (and EU) a greater role in Iran’s development, where China has a special advantage as long as Iran is a pariah. The US would add economic leverage to its military leverage in a region that provides China with its energy. The Chinese are not yet as capable of projecting power into the region but that is changing rapidly. There is a possible strategic balance to be established between these simultaneous foreign policy revolutions: the US-Iran détente, the Israeli-Arab détente, and the rise of Mideast-China ties. But balance is an ideal and not yet a reality. In the meantime these foreign policy revolutions must actually take place – and revolutions are rarely bloodless. It is possible for a meltdown to occur in light of the region’s profound changes. In particular, the US-Iran détente is incomplete and faces Israeli/Arab opposition, Iranian paranoia, and US foreign policy incoherence. At the moment it is premature to declare an end to the bull market in US-Iran tensions. That will come when a deal is actually sealed, and then tested and enforced. In the meantime Iranian incidents will occur (Chart 9). Geopolitical risks threaten to reduce global oil supply. Different regimes and their militant proxies will strike out against each other to establish red lines. But a US-Iran deal is highly likely – and once that occurs, the risk to oil supply shifts to the upside, as Iran’s economy will open up. Not only will Iran start exporting again but Gulf Arab producers will want to preserve their market share, which means they will pump more oil. Iran’s Regime Hardens Its Shell Ahead Of Leadership Succession The COVID-19 crisis has weakened regimes in the Middle East, much like the Great Recession sowed the seeds for the Arab Spring and many other sweeping changes in the region. But unlike the Arab Spring, the regimes most at risk today are majority Shia Muslim – with Lebanon, Iran, and Iraq all teetering on the verge of chaos (Chart 10). Chart 10Iranian Sphere De-Stabilized Amid COVID Chart 11Iranian Economy Weak (Despite Green Shoots) Chart 12Jobless Iranian Youth The Iranian economy is starting to show the faintest green shoots but it is far too soon to give the all-clear signal. US sanctions have shut off access to oil export revenues. Domestic demand is weak and imports are still contracting, albeit much less rapidly. The country has seen a double dip recession over the past ten years (Chart 11). Unemployment is rife, especially among the youth. The working-age population makes up 60% of total and periodically rises up in protest (Chart 12). Inflation is soaring and the currency is still wallowing in deep depreciation (Chart 13). All of these points suggest Iran is weaker than it looks and will seek to negotiate a deal with the Biden administration. But Iran cannot trust the US so it will simultaneously prepare for the worst outcome – no deal, sanctions, and eventually war. Chart 13Iran Still Ripe For Social Unrest Chart 14Iranian Regime Turning HawkishIran’s response to the US’s withdrawal from the 2015 nuclear deal and imposition of maximum pressure sanctions has been to adopt a siege mentality and fortify the regime for a potential military confrontation. The country is preparing for a highly uncertain and vulnerable transition from Supreme Leader Ali Khamenei to a future leader or group of leaders. The government fixed the 2020 parliamentary elections so that hardliners or “principlists” rose to prominence at the expense of independents and especially the so-called reformists. The reformists have been humiliated by the US betrayal of the deal and re-imposition of sanctions, which exploded the economic reforms of President Hassan Rouhani, who will step down in August (Chart 14). The Timeline Of Biden’s Iran Deal Still, it is likely that the US and Iran will return to some form of the 2015 nuclear deal. Lame duck Rouhani is politically capable of returning to the deal: President Rouhani is a lame duck president whose popularity has cratered. If he can restore the deal before August then he can salvage his legacy and provide a pathway for Iran out of economic ruin by removing sanctions. It is manifestly in Iran’s interests to restore the deal – one reason why it has never left the deal and has only made incremental and reversible infractions against it. If Rouhani falls on his sword he provides the Supreme Leader and the next administration with a convenient scapegoat to enable the deal to be restored. Freshman President Biden has enough political capital to return to the deal: Biden is capable of restoring the deal, as he clearly intends to do judging by his statements, cabinet appointments, and diplomatic actions thus far. He has demanded that Iran enter back into full compliance with the deal before he eases sanctions but even this demand can be fudged. After all, it was the US that exited the deal in the first place, and Iran remains in partial compliance, so it stands to reason that the US should make the first concession to bring Iran back into compliance. None of the signatories have nullified the deal other than the US, and it was an executive (not legislative) deal, so President Biden can ultimately rejoin it by fiat. This would not be a popular move at home but the US public is preoccupied. Biden would achieve a foreign policy objective early in his term. The timeline is critical – an early deal is our base case. But if it falls through, then it could take the rest of Biden’s term in office, or longer, to forge a deal. Tensions would skyrocket over that period. The timeline is shown in Table 1. The US has identified April or May as the time when Iran will reach “breakout” capability, i.e. produce enough highly enriched uranium to make a nuclear bomb. The Israelis, for their part, estimate that breakout phase will be reached in August – the same month Rouhani is set to step down. Both the US and Israel view breakout as a red line, though there is some room for interpretation. Table 1Can Lame Duck Rouhani Salvage US Deal For Legacy By August? The option of rejoining the old deal with Rouhani as a scapegoat will end when Rouhani exits in August. The next Iranian president is unlikely to repeat Rouhani’s mistake of pinning his administration on a promise from the Americans that could be revoked as early as January 20, 2025. The next Iranian president will be a nationalist or hardliner. Opinion shows that the public looks most favorably upon the firebrand ex-President Mahmoud Ahmadinejad or the hardline candidate from 2017 Ebrahim Raisi. Another possible candidate is Hossein Dehghan, a brigadier general. The least favorable political figures are the reformists like Rouhani (Chart 15). Chart 15Iran’s Next President Will Be Hawkish We cannot vouch for the quality of these opinion polls but they are corroborated by other polls we have seen and they make sense with what we know and have observed in recent years. Apparently the public has turned its back on the dream of greater economic opening, with self-sufficiency making a comeback in the face of US sanctions (Chart 16). The regime will promote this attitude in advance of the leadership transition as it must be prepared to conduct a smooth succession even under the worst-case scenario of sanctions or war. Chart 16Iran Preparing For Supreme Leader’s Succession Chart 17Nuclear Bomb Key To Regime Survival The hitch is that Iran is interested in rejoining the deal it signed in 2015, not a grander deal. It will not sign an expanded deal that covers its regional militant proxies and ballistic missile program or requires irreversible denuclearization. The Supreme Leader has witnessed that an active nuclear weapon program and ballistic missile program provide the surest guarantees of regime survival over the long haul. The contrasting cases of Libya and North Korea illustrate the point (Chart 17). Libya gave up its nuclear program and weapons of mass destruction in the wake of the US invasion of Iraq in 2003 only to see the regime collapse in 2011 and leader Muammar Gaddafi die under NATO military pressure. By contrast, North Korea refused to give up its nuclear and missile programs and repeatedly cut deals with the US that served only to buy time and ease sanctions, and today North Korea possesses an estimated 30-45 nuclear weapons deliverable through multiple platforms. Leader Kim Jong Un has used this leverage to bargain with the great powers. The lesson for Iran could not be clearer: a short-term deal with the Americans may buy time and a reprieve from sanctions. But total, verifiable, and irreversible denuclearization means regime suicide. The Biden administration would prefer to create a much more robust deal rather than suffer the criticism of rejoining the 2015 deal, given its flaws and that the first set of deadlines in 2025 is only four years away. But Biden cannot possibly reconstruct the P5+1 coalition of countries to force Iran into a grander bargain in the context of US-Russia and US-China tensions. The sacrifices that would be necessary to bring Russia and China on board would not be worth it. Therefore Biden’s solution will be to rejoin the existing deal plus an Iranian promise to enter negotiations on a more comprehensive deal in future. The Iranians can accept this option since it serves their purpose of buying time without making irreversible concessions on their nuclear and missile programs. Israel then becomes the sticking point, as Iranian officials have said that the US rejoining the original 2015 deal would be a “calamity” and unacceptable. The Israeli government is studying options for military action in the event that Iran reaches nuclear breakout. However, the Israeli election on March 23 will determine the fate of Benjamin Netanyahu and his government’s hawkish approach to Iran. A change of government in Israel would likely bring the US and Israel into line on concluding a deal with Iran so as to avoid military conflict for the time being. If Netanyahu wins, yet the US and Iran fall back into compliance with the 2015 deal (Table 2), then Iran is still limiting its nuclear capabilities through 2025, obviating the need for a unilateral Israeli strike in the near term. Israel will not launch a unilateral strike except as a last resort, as it fears permanent alienation from its greatest security guarantor, the United States. Table 2Iran’s Compliance (And Non-Compliance) With The Joint Comprehensive Plan Of Action If a deal cannot be put together by the time Rouhani steps down then the risk of conflict will increase as there will not be a prospect of a short-term fix. A much longer diplomatic arc will be required as Iran would draw out negotiations and the US would have to court allies to pressure Iran. The US and/or Israel could conduct sabotage or air strikes to set back the Iranian nuclear program. It is possible that the Iranian leadership or the increasingly powerful Iranian Revolutionary Guard Corps could overplay their hand in the belief that the US has no stomach for waging war. While it is true that the US public is war-weary, it is also true that that attitude would change overnight in the event of a national humiliation or attack. Investment Takeaways The Trump administration drew a hard line on nuclear proliferation. Trump’s defeat marks a softening in the US line regarding proliferation. This does not mean that the Biden administration will be ineffective – it could be even more effective with a more flexible approach – but it does mean that nuclear aspirants currently feel less pressure to make major concessions. This will hold at least until Biden demonstrates that he too can impose maximum pressure. Hence nuclear and missile tests will go up in the near term – as will various countries’ demonstrations of credible threats and red lines. The global economic recovery will strengthen oil producers by giving them greater government revenues with which to stabilize their domestic politics and restart foreign policy initiatives. The global oil price is reasonably correlated with international conflicts involving oil producers (Chart 18). With rising oil revenues, Russia, Saudi Arabia, Iran, Iraq, and others will be emboldened to pursue their national interests. Chart 18Oil Price And Global Conflict Go Hand In Hand While the Biden administration’s end-game is a nuclear deal with Iran, the period between now and the conclusion of a deal will see an increase rather than a decrease in tensions and tit-for-tat military strikes across the region. Unexpected cutoffs of oil supplies and a risk premium in the oil price will be injected first, as we have argued. When a deal is visible on the horizon then oil prices face a downside risk, due to the resumption of Iranian oil exports and any loss of OPEC 2.0 discipline. It is possible that this moment is already upon us. This report shows a clear path to a US-Iran deal by August. US Secretary of State Anthony Blinken is reaching out to the Iranians. Saudi Arabia has recently announced that it will not continue with large production cuts. Russian oil officials have argued that the global market is balanced and production cuts are no longer necessary.5 But given that the Russians and Saudis fought an oil market share war as recently as last year, it is not clear that a collapse in OPEC 2.0 discipline is imminent. What will be the market impact if hostilities revive in anticipation of a deal? Or worse, if a deal cannot be achieved and a much longer period of US-Iran conflict opens up for Biden’s term in office? Table 3 provides a list of major geopolitical incidents and crises in the Middle East since the Yom Kippur war. We look at the S&P500’s peak and trough within the three months before and after each crisis. The median drawdown is 8% and the market has usually recovered within one month. Twelve months later the S&P is up by 12%. Table 3Stock Market Reaction To Middle East Geopolitical Crises Table 4 shows a shortened list of the same incidents with the impact on the trade-weighted dollar, which is notable in the short run but is only persistent in the long run in the case of full-fledged wars like the first and second Persian Gulf wars. Table 4US Dollar Falls On Middle East Geopolitical Crises The stock market impact can last for a year if the crisis coincides with a bear market and recession. Middle Eastern crises tend to occur at the height of business cycles when economic activity is running hot, inflationary pressures are high, and governments feel confident enough in their economic foundation to take foreign policy risks. The Yom Kippur war and first oil shock initiated a recession in 1973. The first Iraq war also coincided with the onset of a recession. The terrorist attack on the USS Cole occurred near the height of the Dotcom bubble and was followed by the 2001 recession. The 2019 Iranian attack on Saudi Arabia’s Abqaiq refinery also occurred at the peak of the cycle. More analogous to the situation today are crises that occurred in the early stages of the global cycle. The Arab Spring and related events in 2011 coincided with a period of market weakness that lasted for most of the year as the aftershocks of the Great Recession rippled across the emerging world. This scenario is relevant in 2021 and especially 2022, as global stimulus wears off and governments strive to navigate the deceleration in growth. Middle Eastern instability could compound that problem. The chief risk in the coming years would be a failure to resolve the Iranian question followed by a US-Iran or Israel-Iran conflict that generates instability across the Middle East. Such a catastrophe could cause major energy supply shock that would short-circuit the global economy. History shows this risk is more likely to come late in the cycle rather than early but the above analysis indicates that a failure of the Biden administration to conclude a deal this year could lead to a multi-year escalation in strategic tensions with a new hawkish Iranian president. That path, in turn, could bring forward the time frame of a major war and supply shock. The Iranians have taken a hawkish turn, are fortifying their regime for the future, and will reject total denuclearization. The US is fundamentally less interested in the region and thus susceptible to continued foreign policy incoherence. The Israelis are just capable of taking military action on their own in the event of impending Iranian nuclear weaponization. These points suggest that the risk of war with Iran is non-trivial, even though a US-Iran deal is the base case.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Sun Yu and Demetri Sevastopulo, "China targets rare earth export curbs to hobble US defence industry," Financial Times, February 15, 2021, ft.com. 2 For the US response to the Erbil attack see Jim Garamone, "Austin Pleased With Discussions With NATO Leaders," Department of Defense News, February 17, 2021, defense.gov. 3 For example, Biden is unlikely to withdraw precipitously from the region, including Afghanistan, as Trump intended, especially as long as he is in a high-stakes negotiation with Iran. 4 Ruth Igielnik and Kim Parker, "Majorities of U.S. veterans, public say the wars in Iraq and Afghanistan were not worth fighting," Pew Research, July 10, 2019, pewresearch.org. 5 See Benoit Faucon and Summer Said, "Saudi Arabia Set to Raise Oil Output Amid Recovery in Prices," Wall Street Journal, February 17, 2021, wsj.com; Yuliya Fedorinova and Olga Tanas, "Global Oil Markets Are Now Balanced, Russia’s Novak Says," Bloomberg, February 14, 2021, Bloomberg.com.

Highlights Transitory dislocations – i.e., supply and demand disruptions in the wake of the Polar Vortex engulfing the US midcontinent – are wreaking havoc on spot oil markets; however, they will not profoundly alter longer-term fundamentals (Chart of the Week). Gasoline prices in the US are up 10 cents/gal this month, as are diesel prices, indicating the impact on production and consumption is affecting the former slightly more at the margin.  In the hard-hit Midwest and US Gulf regions, price gains are slightly less, according to the US EIA. Oil production in the vanguard Permian Basin likely will fall 7-8mm barrels this month. Refineries and pipelines experiencing power outages and severe cold are reducing operations, which will dampen exports. The weather-induced rally pushed Brent above $63/bbl this week, our average price forecast for this year in January. This month, we are lifting our 2021 average price forecast back to $65/bbl and lowering our 2022 forecast slightly to $70/bbl. The balance of price risks remains to the upside. Nonetheless, we remain cautious given ongoing COVID-19 risks – particularly around variants; a strong USD; and the resumption of Saudi-Russian tensions that likely will arise within OPEC 2.0 with prices above $60/bbl. Feature Despite headline-grabbing reports of the Polar Vortex engulfing the US Midwest and Gulf regions, supply-demand fundamentals are unlikely to experience a prolonged dislocation in its wake.  Oil output likely will be hit hard in the short term, particularly in the Permian Basin, where producers, by and large, are unaccustomed to the deep-freeze conditions their colleagues to the north take for granted.  We expect some 7-8mm barrels of production will be lost in the Permian this month, but that it will be returned next month, which will restore US output to its previous trajectory (Chart 2). Chart of the WeekOil Forecasts Steady, Despite Polar Vortex Chart 2Lost US Oil Ouput Will Return In March Operations at refineries and pipelines are ramping down as a precaution, which will force product inventories to draw as temperatures return to normal.1 This will reduce exports until refining assets and pipelines are brought back up to speed as refiners prepare for the summer driving season.  With vaccine distribution in the US picking up steam, we expect product demand to rise, and, given the lost oil and refining output from the current weather-induced disruptions, we expect refining margins in 2Q21 and 3Q21 to be stout. Global Oil Markets Remain Steady Our global oil balances are largely unchanged versus last month, save for a few marginal adjustments, leaving our price forecasts largely unchanged. The weather-induced push to prices that lifted Brent to our $63/bbl forecast from last month ahead of schedule – mostly as lost US production opened short-term sales opportunities for Brent-related crudes – will recede, producing a shallow correction as markets return to normal.  Thereafter, in 2Q21, we expect global supply-demand fundamentals to resume the pre-winter evolution we have been modeling for months.  WTI prices, which were pushed above $60/bbl this week, also will recede in the short term as weather returns to normal. On the demand side, we continue to expect a stout recovery in DM and EM markets, with consumption gaining 6.6mm b/d this year and 2.8mm b/d in 2022 on the back of massive fiscal and monetary stimulus globally (Chart 3).  We expect supply to continue reflecting the production management of OPEC 2.0 (Chart 4), which has been remarkably successful in keeping the level of supply below demand (Chart 5), which is driving the drawdown in global inventory levels (Chart 6).  OPEC 2.0’s strategy likely will be maintained into 2022, however, as we discuss below, this is not a given (Table 1). Chart 3Stout EM, DM Demand Expected Chart 4OPEC 2.0 Production Will Respond Quickly To Demand Changes Chart 5OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 6...Allowing Inventories To Draw Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) US Real Rates Keep USD Bid US nominal rates are increasing while inflation has yet to show up in the data, which means implied real rates are rising.  This has been supporting the USD and keeping it well bid in the new year (Chart 7). We continue to expect a weaker USD – given the massive fiscal stimulus and support measures deployed globally, particularly in the US. The Fed continues to signal it will continue to accommodate as much debt as the government takes on to support America’s recovery from COVID-19 and reduce unemployment. Global Economic Policy Uncertainty continues to fall as pandemic uncertainty falls.  This will bring the USD down with it, as demand for safe havens diminishes along with lower uncertainty.2 However, markets still remain highly sensitive to any news suggesting the struggle to contain the COVID-19 pandemic is tipping in favor of the virus. Chart 7US Real Rates Keep USD Well Bid OPEC 2.0 Tensions Will Follow Prices OPEC 2.0 has been remarkably consistent in its adherence to a policy of calibrating production to demand, so much so that even as demand was collapsing during the worst of the COVID-19 pandemic global inventories fell.  This is the result of a deliberate effort by OPEC 2.0 to keep the level of supply below demand.  In so doing, markets tightened, prices rose, and forward curves backwardated as inventories drew down, as we have been expecting for months (Chart 8). Going forward, as prices continue to strengthen – we expect Brent to average $65/bbl and $70/bbl this year and next – the cohesion of the OPEC 2.0 coalition again will be tested by differing domestic policy goals in the Kingdom of Saudi Arabia (KSA) and Russia. Chart 8Forward Curves Backwardate In Line With OPEC 2.0 Policy Our maintained hypothesis in assessing oil-market supply-demand fundamentals is KSA and Russia are trying to strike a balance between their disparate goals: KSA needs higher prices to support its diversification efforts away from oil exports as the principal driver of its economy, and Russia desires lower prices so as to discourage another surge in US shale-oil output.  In our estimation, for the near term – i.e., the next 2-3 years – KSA prefers Brent prices in a range of $70-$75/bbl, while Russia prefers prices in a range of $50-$55/bbl.3 In the best of all possible worlds, maintaining OPEC 2.0 cohesion likely represents a compromise that keeps Brent prices somewhere between $60-$70/bbl, perhaps a touch lower.  Our modeling assumption is $65/bbl is a policy variable KSA and Russia can accept, and can agree to manage their production around that level.  Brief excursions below and above the $65/bbl level are acceptable to both sides, but neither expects an excursion favoring their desired price level to endure indefinitely.  Nor, we believe, do they expect the other side to countenance supporting their target at the expense of their domestic goals. At present, with Brent prices gravitating toward that ideal midpoint (at least in our estimation) of $65/bbl, markets will begin looking for signs the OPEC 2.0 alliance once again will start to fray, as it did in March 2020, when KSA and Russia could not agree on the level of production cuts at the start of the COVID-19 pandemic. At that time, Russia effectively declared a market-share war, which was readily engaged by KSA. Our prior – every month when we re-estimate supply-demand balances, and price forecasts – is both sides are sufficiently sensitive now to the damage they can inflict on the other, which, of course, also damages their economic interests. To borrow a well-turned phrase from the Bard, “Things should start to get interesting right about now.”4   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 Words fail to describe the price surges seen in US natural gas markets, which, on at least one pipeline system squarely situated along the cold front engulfing the midcontinent, surged to $500/MMBtu in spot trading going into this past weekend.  The Polar Vortex powering through the midcontinent brought sub-zero temperatures and snow as far south as Galveston, TX.5 In futures trading, March-delivery futures in Henry Hub, LA, traded above $3.20/MMBtu earlier this week and settled above $3.10/MMBtu as we went to press (Chart 9).  Base Metals: Bullish At ~ $3.85/lb, copper prices are trading at levels not seen since the beginning of 2012 on the CME’s COMEX exchange.  Falling on-exchange inventories globally are contributing to bullish sentiment, as we discussed last week.6  Key markets – e.g., iron ore, which is holding ~ $160/MT, and nickel at ~ $18,800/MT – remain well bid during the Lunar New Year in China, when liquidity typically falls (Chart 10).  We are getting tactically long spot London nickel at tonight’s close, with a price target of $29,000/MT by July.  Precious Metals: Bullish Silver is holding up better than gold, which moved sharply lower as US real rates rose on the back of higher 10-year bond yields, which went from 1.2% on Friday to 1.3% on Tuesday, a one-year high.  We remain long gold, and are getting tactically long silver at tonight’s close.  We expect COMEX silver to reach $30/oz by July, as supply tightens, and demand increases on the back of a recovery in DM and EM economies. Ags/Softs: Neutral Wheat moved higher this week in the wake of the Polar Vortex sweeping through the US midcontinent, which raised fears of a winter crop kill-off as temperatures dropped well below zero (F) in key crop regions.  Corn prices also moved higher, reversing WASDE-induced selling last week. Chart 9Prices Surge In US Natgas Markets Chart 10Nickel Remains Well-Bid During The Lunar New Year   Footnotes 1     Please see U.S. oil wells, refineries shut as winter storm hits energy sector, posted by reuters.com for a summary of refinery and pipeline outages in oil and gas markets in the US midcontinent and Gulf regions.   2     Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, which we published 28 January 2021, for additional discussion on the interplay of these factors. 3    In our estimation, Russia’s budget is geared toward a Urals price of $42/bbl, while KSA’s likely assumes a price closer to $65/bbl.  Please see Saudi Arabia's 'realistic' 2020 budget assumes lower oil price than 2019: economists published by S&P Global Platts 19 Dec 2019, and “Falling oil prices threaten to derail Putin’s spending promises,” published by ft.com 2 March 2020. 4    This is a line from a song titled Mississippi, which is found on Bob Dylan’s “Love And Theft” album.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Overweight In an Insight in mid-October we referred to the 10-year US Treasury yield as a sleeping giant and reiterated that this asset class was the last one that had yet to respond to the Fed’s QE as we had first highlighted on March 23, 2020. Now, there is tentative evidence that the giant has awaken – it even surpassed its last March peak. Encouragingly, it is also lifting the S&P financials index out of its misery (Chart 1, top panel). We boosted the financials sector to overweight in mid-November and as long as bonds sell off, investors will continue to bid financials higher. Importantly, the shape of the yield curve further underpins financials especially given the Fed’s resolve to keep short rates pinned near zero and continue to engineer a steeping of the yield curve. (Chart 1, bottom panel). The implication is that relative profitability will pick up steam, a message that our macro-driven relative EPS models also corroborate (Chart 2 on the next page). Tack on pent up financials sector buyback demand and a 40bps dividend yield carry versus the SPX and the outlook remains rosy for this early-cyclical sector. Bottom Line: Remain overweight the S&P financials sector.

Highlights Health care remains a top priority of the Democratic Party even though it is flying under the radar at the moment. Health care embodies the shift from small government to big government. While the 2021 budget reconciliation will hit Big Pharma and expand Medicaid, the 2022 reconciliation will seek a public health insurance option and Medicare role in price negotiations. If forced to choose between health care and climate change priorities, Democrats will choose health care. It is a bigger vote-winner. Stay short managed health care relative to the S&P 500. Go long health care facilities and equipment relative to the rest of the health sector. Feature The US Senate acquitted former President Donald Trump on a vote of 57-43 on February 13. No one was hanged.1 The trial was not economically or financially significant except insofar as it underscored peak US political polarization, US distraction from the global stage, and the extent of divisions within the Republican Party. Equity market volatility melted away as stocks surged higher on the generally positive backdrop of COVID vaccines and stimulus.   Seven Republicans joined Democrats in voting to convict the former president of “incitement to insurrection.” Trump’s performance was worse than Bill Clinton’s but better than Andrew Johnson’s, though neither Clinton nor Johnson saw defections from their own party (Chart 1). The Republicans’ internal differences are serious enough to hobble them in the 2022 or 2024 elections but it is too soon to draw any hard conclusions. The Democratic agenda is also capable of bringing Republicans back together. Meanwhile the maximum of seven Republican defectors shows that it will be extremely difficult for Democrats to get 10 Republicans to join them in passing any controversial legislation in the Senate (Table 1). Hence the filibuster will remain in jeopardy over the long run if not in the short run. Also, in 2022, the Democrats have a chance to pick up seats in Pennsylvania and North Carolina. Chart 1Trump’s Acquittal And Historic Impeachment Results Table 1The Seven Senate Republicans Who Defected From Trump Biden’s Agenda After The American Rescue Plan Democrats are plowing forward with the first of two budget reconciliation bills, which enables them to pass legislation with a simple majority in the Senate. They hope to pass President Biden’s $1.9 trillion American Rescue Plan by mid-March, when unemployment benefits expire under the Consolidated Appropriations Act of 2020. The final sum might be a bit less than this headline number. The second budget reconciliation bill, for fiscal year 2022, will be passed in the autumn or next spring and will contain anywhere from $4 trillion to $8 trillion worth of additional spending on health care, child care, infrastructure, and green projects over a ten-year period (Chart 2). This number will be watered down in negotiation as the pandemic subsides and the aura of crisis dies down, reducing the willingness of moderate Democrats to vote for anything controversial. But investors should not doubt Biden’s agenda at this stage. If there is anything we know about the reconciliation process it is that the ruling party will get what it wants. Investors should plan accordingly: the output gap will be closed sooner than expected and inflationary pressures will build faster than expected, even though it will take a while for the labor market to heal. Chart 2Biden’s Agenda AFTER The American Rescue Plan This policy combination of “loose fiscal, loose monetary” policy continues to drive stocks higher (and the dollar lower) despite the misgivings we noted about underrated geopolitical risks (Chart 3). A critical question is when the Fed will normalize monetary policy. This is not an apolitical question. Fed chair Jerome Powell’s term ends in February of 2022. He may contemplate tapering asset purchases prior to that date, causing troubles in the equity market, but actual tapering is more likely to occur in 2022, in the view of our US Bond Strategist Ryan Swift. Powell would only taper in 2022 if he is forced to do so by an ironclad policy consensus precipitated by robust inflation and possibly financial instability concerns. This timing gives President Biden an opportunity to nominate an ultra-dovish Fed chair. Rate hikes are entirely possible in 2022 but our political bias implies they are unlikely before 2023 (unless an ironclad consensus develops that they are necessary). Even in 2023, an ultra-dove will be reluctant to hike, depending on the context. And rate hikes are virtually off limits in 2024, at least until after the November election. This political timeline reinforces the view that the Fed will not be hiking anytime soon and investors should prepare for inflation risks to surprise to the upside over the coming years. Chart 3"Easy Fiscal, Easy Monetary" Policy Combination The Senate parliamentarian has not yet ruled whether a federal minimum wage hike to $15 per hour can be included in the bill. Biden has accepted it may be cut but his party will push it through if possible. Last week we found that a higher minimum wage would not have a dramatic macroeconomic impact. Still, wages will rise in the coming years due to the cumulative effect of the Democratic Party’s policies. Higher wages, taxes, and regulatory hurdles will cut into corporate profits. But the passage of a higher minimum wage today would not in itself be a negative catalyst for equities. Rather, we would expect the rally to take a breather once the first reconciliation bill is finished (next week or in the coming weeks), since it will bring wage hikes, rate hikes, and tax hikes more clearly into view on the investment horizon.  Unlike minimum wages, there is little controversy over whether budget reconciliation can be used to change the health care system. This was done in 2010 as the second critical part to President Barack Obama’s Affordable Care Act (Obamacare). Hence Biden is highly likely to get his health agenda passed, which is largely an agenda of entrenching and expanding Obamacare. That is, as long as he prioritizes health care above other structural reforms like climate change. We think he will. In the rest of this report we look at Biden’s health care policy and the implications for US financial markets. Biden’s Health Care Policy Health care has been a top priority of the Democrats since 1992 yet they have repeatedly lost control of the agenda due to surprise Republican victories in 2000 and 2016. Republicans expanded Medicare under Bush but then failed to repeal and replace Obamacare under Trump. Now Democrats have only the narrowest of majorities in the House and Senate and will push hard to solidify and build on Obamacare. There is a low chance that they will leave this issue unsettled under the Biden administration. If new obstacles arise, more political capital will be spent to secure health care reform at the expense of other policies on the agenda. COVID-19 reinforces the Democrats’ focus on health care. The US has seen around 1,500 deaths per million people, making it one of the worst performers amid the crisis, comparable to the UK and Italy (Chart 4). Yet COVID is only the latest in a line of US public health failings and it is important to put COVID into perspective. For example, among US adults aged 25-44 years old, all-cause excess mortality from March to July last year was about 11,899 more than expected. By contrast, during the same period in 2018, there were 10,347 unintentional deaths due to opioids (Chart 5).2 In other words, the COVID crisis last year was comparable to the opioid crisis in magnitude, at least for middle-aged people. Obviously COVID has taken a terrible toll and is a more deadly disease for the old and the sick. The point is that the public’s wrath over poor public health and the US government’s ineffectiveness is well established. A pandemic was foreseeable, and foreseen, yet not prepared for, and it came on top of the opioid crisis and the debate about 30 million Americans who lack health insurance. The Biden administration has the intention and the capability to address these issues. Chart 4US Handling Of COVID-19 Left Much To Be Desired   Chart 5Opioid Crisis Versus COVID Crisis  The structural problem is well-known: The US spends more than other countries on health care but achieves worse results (Charts 6A & 6B). When workers get fired they lose health care, as insurance is tied to employment. Those whose employers do not provide health care or who are unemployed count among the ranks of the roughly 30 million uninsured. This number has fallen from its peak at 47 million in 2010 when Obamacare was enacted but has crept upward again since Trump’s attempt to dismantle that law and the lockdowns of 2020 (Chart 7). This is a driver of popular discontent that has proven again and again to generate votes, including in key swing states. Chart 6AThe US Spends More On Health Care … Chart 6B… But Sees Worse Avoidable Mortality Chart 7Rising Number Of Uninsured Even Pre-COVID A range of public opinion polling over many years shows that health care is a close second or third to the economy and jobs in voter priorities. Voters care more about COVID and health care than they do about climate change and the environment (Chart 8, first panel). Chart 8Public Opinion On Biden’s Priorities: Jobs, Health, Then Climate Another important takeaway from this opinion polling is that voters could not care less about budget deficits. Big spending solutions are all the rage (Chart 8, second panel). The Biden administration is prioritizing economic recovery and the pandemic response but will also pursue its health care reforms. If this policy requires a tradeoff with infrastructure and renewables, we would expect health care to get the greater attention.  Over the long run Obamacare can be replaced but not repealed. The law is getting more popular over time and entitlements get harder to repeal over time. Slightly more than half of voters have a favorable view of the law and only 34% have an unfavorable view. Only 29%of voters want to repeal or scale back the law while about 62% want to build on it or keep it as it is (Chart 9). Underscoring this polling is the fact that the law was modeled on a Republican plan and even Trump adopted several of the most popular provisions: requiring insurance coverage for patients with preexisting conditions and slapping caps on pharmaceutical prices through import and pricing schemes. The Supreme Court has ruled Obamacare constitutional and is not expected to change that ruling this spring. It could object to the individual mandate – the most controversial part of Obamacare that required each person to pay a tax penalty if they did not purchase health insurance. But if parts of the law are stricken, Democrats have the votes to patch it up or provide an alternative.  Chart 9Obamacare Has Grown On American Public Biden simultaneously shows that Democrats rejected the most popular alternative to Obamacare – “Medicare for All,” or single-payer government-provided health care – at least for the current presidential cycle. Medicare for All was co-sponsored by Vice President Kamala Harris and is still a long-term goal of the progressive wing of the Democratic Party. However, voters do not like the proposal when asked about its practical consequences (Chart 10). In the Democratic primary, only Senators Bernie Sanders and Elizabeth Warren argued for wholesale revolution in US health care that would see private insurance cease to exist and 176 million voters moved onto a public health system. Sanders’s plan would have cost an estimated $31 trillion, increasing the budget deficit by $13 trillion over 10 years, and would have encouraged the overuse of medical services due to the absence of a co-pay or fixed cost. This idea will not vanish but the Biden administration’s likely success in expanding Obamacare will lead the party to focus on other things (e.g. climate change). Chart 10Insufficient Public Demand For Government-Provided Health Care (For Now) Biden’s big proposal is to add a public insurance option that would exist alongside current private insurance options. This idea was originally part of Obamacare but was removed during negotiations – precisely because the Democrats eschewed the use of budget reconciliation (again, not a constraint this time).3 The Biden plan is estimated to cost $2.25 trillion over 10 years and includes larger subsidies, the ability of workers to choose whether they want their employer-provided plan or the public option, automatic enrollment, a lower age of eligibility for Medicare (from 65 to 60), drug price caps, and various other provisions (Table 2). Table 2Biden’s Health Care Plan Medicare, a giant consumer, would be able to negotiate drug prices directly with companies to drive down the price. Tax hikes on high-income earners and capital gains would pay for Biden’s policy.  With public backing and full Democratic control of Congress, there is little that can stop Biden from achieving this health care policy, other than a change in direction from his party, which we do not expect. The first budget reconciliation only contains small parts of the Biden agenda, such as incentives for states to expand Medicaid under Obamacare and a reduction in Medicaid rebates for drug manufacturers.4 The second budget reconciliation process will have to cover health care and tax hikes. But the consensus view is that the second reconciliation will focus on infrastructure and green energy. This is a conflict of priorities that will have to be resolved. The research above suggests it will be resolved in favor of health care. This would leave the regular budget process as the means to advance infrastructure and green projects. Macro Impact Of Biden’s Health Care Policy The great health care debate over the past decade reflected the broad post-Cold War debate in the US over the role of government in the economy. It centered on whether government involvement should increase to expand health insurance coverage. Although private US health care spending accounts for 31% of total health care spending, and is thus larger than either Medicare (21%) or Medicaid (16%), the government has control of 44% of spending when all of its functions are added together. This share is set to increase now that the debate has been decided in favor of Big Government (at least for now). Future administrations might carve out more space for private choice and competition in health care but a permanent step-up in government involvement and regulation has occurred given the above points about Obamacare’s irrevocability. What are the macro consequences of such a change?   The imposition of Obamacare may have contributed to the sluggish economic recovery in the wake of the Great Recession but the case is hard to examine objectively because the tax penalties only took effect in 2015-16 and then a new administration ceased implementation in 2017. In 2015 the Congressional Budget Office estimated that repealing Obamacare would increase the budget deficit by $353 billion over a ten year period but that it would also increase GDP by an average of 0.7% per year during the latter end of full implementation, thus boosting revenues and producing a net $137 billion increase in the budget deficit over ten years.5 In other words, Obamacare marginally tightened fiscal policy and encouraged some workers to cut their hours or stop working due to expanded subsidies, tax credits, and Medicaid eligibility.6 Repealing it would have reduced the tax burden on corporations and reduced the subsidy benefits to households but possibly with a slight boost to growth (Chart 11). Going forward, Biden’s policies are adjustments rather than a total overhaul but they would ostensibly add $2.25 trillion in spending and $1.4 trillion in revenue, resulting in a negative impact on the budget deficit (fiscal loosening) of $850 billion. The implication is that Biden’s plan would increase rather than decrease aggregate demand, albeit marginally in an era of already gigantic deficits. It would also remove some labor supply and eventually drag on GDP growth. Yet the impact of these effects is still uncertain given the general context of loose fiscal and loose monetary policy, the reduction in the number of uninsured people, and the potentially positive second-order effects of this increase in the social safety net for low-income families with high marginal propensities to consume. The bottom line is that the macro effects of Biden’s health plan will not be known for many years but the headline effect in the short run is an incremental addition to an already extremely loose fiscal policy setting.  Chart 11Macro Effects Of Obamacare Repeal The negative effects will largely fall on high-income earners, capital gains earners, and corporations who will provide the revenue to pay for the plan. The private health insurance industry faced an existential threat from the Sanders plan but it still faces a loss of customers and earnings from the Biden plan. The major difference between Obamacare and Bidencare is that Obamacare forced insurance companies to provide a basic insurance option to the public but did not offer a public option to compete with them. Therefore their customer base increased albeit at a lower profit. Whereas Biden’s plan will create a public competitor that will siphon off customers from private insurance. Biden proposed giving workers this choice anytime but in the presidential debates suggested there would be limits. Either way private insurers stand to lose customers over time. This is not a major political constraint given that Big Insurance gets little sympathy from the public but it will have a negative impact on innovation and productivity in the health sector. Meanwhile Medicare would reimburse hospitals, clinics, and drug providers less for their services and goods. This would weigh on the profitability of small and private medical outfits and favor large and public providers that receive government subsidies and can stomach higher costs. It would also take a toll on Big Pharma and biotech sectors which have operated in a lucrative environment of low taxes, low regulation, and sizable pricing power. The US government has enormous negotiating power in the market, especially over home care, hospitals, nursing homes, and prescription drugs. Private and public investment are roughly evenly split, with public money dominating health care research and private money dominating structures and equipment. The government accounts for about 40% of total drug spending and both political parties believe this influence should be used to keep costs down, as public opinion is increasingly dissatisfied with high drug costs.7 There is a lot more to be said about the US health care system. A risk of Biden’s health reform is that it will increase the demand for health services without arranging for consummate increases in supply. In this sense it is inflationary. Investment Takeaways Health care stocks and each of the health care sub-sectors – pharmaceuticals, biotech, managed health care, facilities, and equipment – underperformed the S&P500 index amid the passage of Obamacare from March 23 to November 20, 2010. Within the sector, managed health care (health insurance) and biotech suffered most when the legislation first hit while facilities and equipment suffered most over the whole legislative episode. Once the law took full effect in 2014-15, equipment and managed health care outperformed, facilities were flat, and pharma and biotech underperformed. A look at the performance of the health care sector relative to the S&P 500 over the past 13 years shows that the sector rallied on President Obama’s victories in 2008, fell during the passage of Obamacare, staged a recovery that continued through the Supreme Court’s decision to uphold the new law in June of 2012, and then dropped off (Chart 12 A). Health stocks benefited from the global macro backdrop from 2011-15. After 2015, when Obamacare took full effect, the business cycle entered its later stage, and populism emerged (with Sanders threatening a government takeover and Trump firing up the cyclical economy), health care stocks underperformed the market. Chart 12AHealth Sector's Response To Obamacare Saga Subsequent rallies have occurred, notably on the outbreak of COVID-19, but have not been sustainable. When Republicans failed to repeal Obamacare, when various crises gave defensive plays a tailwind, when Biden won the Democratic nomination over Sanders or Warren, and when the pandemic arose, the sector surged, often due to risk aversion in financial markets. In the end the negative trend reasserted itself as the combination of rising risk sentiment and policy headwinds outweighed the underlying demographic tailwind for earnings as society aged. Since the Democratic sweep of government in the 2020 elections the sector is testing new lows in relative performance. Pharmaceuticals charted a similar course to the overall health sector but never regained their pre-Obamacare peak in relative performance. They have underperformed again and again since the rise of Bernie Sanders and are today touching new lows (Chart 12B). Chart 12BBig Pharma's Response To Obamacare Saga A closer look at the sector since the 2020 election and especially the Democratic victory in the Senate shows that it continues to underperform the broad market. Facilities are the most resilient, pharma and biotech are trying to find a bottom, and equipment and managed health care have sold off. Relative to the health care sector, equipment and facilities are the outperformers but, again, pharma and biotech are trying to bottom (Chart 13). These results make sense as Biden’s biggest policy impact will be to stimulate demand for health care facilities and equipment while constraining profits for Big Insurance and Big Pharma via the public insurance option and allowing Medicare to negotiate drug prices. Thus equipment and facilities benefit from the political environment, pharma and biotech should be monitored to see if they break down to new lows on the passage of legislation, and managed health care gets the short end of the stick. Our US Equity Strategy service is neutral on the sector as a whole, overweight equipment, and underweight pharma. Chart 13Health Care Sector Response To Biden's Democratic Sweep Putting it all together, health care stocks are good candidates for a short-term, tactical bounce when the exuberant stock rally suffers a correction but they are not yet candidates for strategic investments. They are not likely to find a bottom until Biden’s policies are passed, or the pro-cyclical macro backdrop has changed. Biden’s policies are high priority for his party and face low legislative and political hurdles to passage, yet will have a huge impact on the relevant industries – undercutting the private health insurance customer base and capping the profits of America’s drug makers. These changes will have long-term ramifications so they are not likely to be fully discounted yet. Previously health care firms had huge pricing power – they could charge whatever they wanted while they did not face the full might of the government in setting prices – but going forward that will change. Biotech and pharma have large profit margins that are exposed to this policy shift so they are exposed to further downside – we would not be bottom-feeders. Moreover pharmaceuticals make up 28% of the health sector while biotech makes up 13%, so that these sectors will weigh down the whole sector. One would think that health care would outperform during a global pandemic – and most sectors did see a big bounce during the height of the COVID-19 outbreak. But the pandemic has created the impetus for a stimulus splurge that has fired up the cyclical parts of the economy. It has also underscored the industry’s public role and undercut its profit-making capabilities, not least by producing a Democratic sweep bent on improving US health outcomes – at the expense of US health industry profits. In sum, from a tactical point of view, health care stocks are well-positioned for a near-term rally in relative performance but from a strategic point of view they continue to face policy headwinds and should be underweighted relative to the broad S&P 500. Tactically, stay short the managed health care sub-sector relative to the S&P 500 (Chart 14). Strategically, go long health care facilities and equipment relative to the health care sector. Chart 14Health Stocks Outlook Under Biden Administration     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Table A1BPolitical Capital: Household And Business Sentiment Table A1CPolitical Capital: The Economy And Markets Table A2Political Risk Matrix Table A3Biden’s Cabinet Position Appointments           Footnotes 1     During the election crisis [of 1876], Kentucky Democrat Henry Watterson urged that “a hundred thousand petitioners” and “ten thousand unarmed Kentuckians” go to Washington to see that justice was done. Years later, when he was sitting next to [Ulysses S.] Grant at a dinner party, Watterson told him, “I have a bone to pick with you.” “Well, what is it?” asked Grant. “You remember in 1876,” said Watterson, “when it was said I was coming to Washington at the head of a regiment, and you said you would hang me if I came.” “Oh, no,” cried Grant, “I never said that.” “I am glad to hear it,” smiled Watterson. “I like you better than ever.” “But,” added Grant drily, “I would, if you had come.” See Paul F. Boller, Jr, Presidential Campaigns: From George Washington To George W. Bush (Oxford: Oxford University Press, 2004 [1984]), p. 141. 2     See Jeremy Samuel Faust, Harlan M. Krumholz, and Chengan Du, “All-Cause Excess Mortality and COVID-19-Related Mortality Among US Adults Aged 25-44 Years, March-July 2020,” Journal of the American Medical Association, December 16, 2020, jamanetwork.com. 3    The death of Senator Edward Kennedy forced the Democrats to use reconciliation for the second part of President Obama’s health care reform, the Healthcare and Education Reconciliation Act of 2010.  4    Currently the Medicaid rebate cap is set at 100% of the cost of making a drug. Other provisions would include a boost for rural health care services (a partial reallocation of headline COVID relief funds) and an expansion of Obamacare tax credits and subsidies for unemployed workers to keep their former employer-provided insurance. These are mainly COVID relief measures rather than aspects of Biden’s long-term health agenda. See Julie Rovner, “KHN’s ‘What the Health?’: All About Budget Reconciliation,” Kaiser Family Foundation, February 11, 2021, khn.org; see also Nick Hut, “A look at some of the healthcare-specific provisions in the pending COVID-19 relief legislation,” Healthcare Financial Management Association, February 10, 2021, hfma.org. 5    For the CBO’s original report on repeal, see “Budgetary and Economic Effects of Repealing the Affordable Care Act,” Congressional Budget Office, June 19, 2015, cbo.gov. More recently see Paul N. Van de Water, “Affordable Care Act Still Reduces Deficits, Despite Tax Repeals,” Center for Budget and Policy Priorities, January 9, 2020, cbpp.org. 6    See BCA Global Investment Strategy, “The Fed’s Dilemma,” May 12, 2017 and “Four Key Questions On The 2018 Global Growth Outlook,” January 5, 2018, bcaresearch.com. Regarding the debate around Obamacare, promoters highlight the recovery in US growth and jobs – including full-time jobs and small-business jobs – by 2015. Critics say the recovery would have been stronger if not for the law. See e.g. Casey B. Mulligan, “Has Obamacare Been Good for the Economy?” Manhattan Institute, Issues Brief, June 27, 2016, manhattan-institute.org; Cathy Schoen, “The Affordable Care Act and the U.S. Economy: A Five-Year Perspective,” Commonwealth Fund, February 2016, commonwealthfund.org. 7     Republican Senator Chuck Grassley co-sponsored a bill with his Democratic counterpart Ron Wyden of Oregon that would penalize drug companies that raised drug prices faster than inflation. In a separate bill with Senator Amy Klobuchar of Minnesota, he also proposed to prevent big name drug companies from paying generic drug-makers to delay the introduction of generics to the market. These bills were not debated on the main floor because then-Senate Majority Leader Mitch McConnell was unenthused about them but they exemplify the bipartisan consensus on government intervention to push down drug prices.