通貨

Highlights The Canadian economy is usually a high-beta play on global growth. However, given the stop-and-go pattern of the pandemic, Canada might lag the global recovery for now. The Bank of Canada’s (BoC) stance will be to fade any near-term improvement in the economy. This will cap Canadian yields in the interim, and act as a drag on an appreciating currency. That said, this would only provide a coiled spring for Canadian yields and the currency once the global economy is on more solid footing. Stay neutral Canadian government bonds in a global portfolio for now, but place on downgrade watch. The driver for CAD/USD is shifting from relative interest rates to terms of trade. Rising oil prices are a positive. CAD/USD should continue to rise for the rest of the year, but will underperform the NOK. The CAD should also outperform a basket of oil consumers such as the EUR, INR, and the TRY. Feature Canada has typically been a high-beta economy, but the Covid-19 crisis has certainly dented the traditional relationship. Chart 1 shows that for much of the last two decades, Canadian growth has outpaced that of its G10 peers during the expansionary phase of an economic cycle. The IMF predicts that the same cycle might not play out over the next two years. Real GDP growth estimates for both 2021 and 2022 in Canada are 3.6% and 4.1%, in line with the G10 over this period. Meanwhile, the accuracy and relevance of these estimates will be highly dependent on the rapidly changing nature of the pandemic. Importantly, high-frequency Canadian growth estimates are already relapsing, as the Covid-19 crisis has induced widespread lockdowns and brought economic activity to a standstill. The Canadian PMI has collapsed relative to the rest of the G10. The risk is that this will lead to a weaker exchange rate (Chart 2) and softer bond yields than normal. Chart 1Canadian Growth Usually Outperforms In Expansions Chart 2Relative Growth Relapsing ##br##In Canada In this Special Report, jointly written with BCA’s Global Fixed Income Strategy, we explore whether the Canadian recovery will lead or lag the global cycle. This has implications for relative monetary policy, the exchange rate, and bond yields. Canada has usually been a holy grail for foreign direct investment and portfolio flows due to its greater reliance on export growth, commodity demand, and the economy’s lever to the manufacturing cycle. Our bias is that this time around, the recovery could be delayed as the authorities fend off the pandemic, keeping monetary policy dovish and capping Canadian bond yields relative to the US. This will change later this year as the narrative around the pandemic evolves. Canada To Lag, For Now The slowdown in economic activity in Canada coincided with a rapid expansion in the number of new Covid-19 cases, as the northern hemisphere stepped into the winter months. This has led to Canada implementing one of the most stringent lockdown measures around the world. According to Map 1 as of February 10, Canada sat in the top quartile ranking of restrictive measures. Map 1Very Stringent Lockdown Measures In Canada At first blush, Canada ranks quite well in terms of vaccine coverage, relative to the number of new infections (Chart 3). However, progress on the vaccination front has been underwhelming. Canada has vaccinated around 3% of its population, far less than most other G10 economies (Chart 4). The reason is a vaccine shortage, as other countries prioritize local inoculations. There have also been production hiccups. In the interim, this will subdue economic activity relative to the level of potential growth. Chart 3Great Starting Point For Canada,... Chart 4...But Low Vaccine Roll-Out The service industry is crucial to return the economy to full employment, and the leisure and hospitality sectors have been hit particularly hard. Over the last year, Canada has lost 572K jobs. 92% of these have been service related and 60% have been in the accommodation, food services, wholesale trade, and  retail trade sectors. This is keeping a lid on overall consumer and business confidence measures. Unless it becomes safer for these workers to return to work, this will continue to be a drag on consumption. While the unemployment rate in Canada peaked below that in the US, the jobs recovery has been more muted (Chart 5). Chart 5A Slower Jobs Recovery ##br##Than The US Chart 6Strong Potential For A Coiled-Spring Rebound That said, it has not all been negative news. Retail sales were very robust for the month of November, suggesting a high propensity for the economy to regain vigor once lockdown measures are eased. While there was some element of restocking ahead of new restrictive measures, retail sales have been robust throughout the recovery (Chart 6, top panel). The steady rise in oil prices, along with the recovery in the global business cycle, is also boosting capital-spending intentions (Chart 6, middle panel). This will be an added boost to GDP growth. The latest BoC Business Outlook Survey saw the biggest improvement in the sales outlook in a decade (Chart 6, bottom panel). Improving foreign demand, especially from the US, was a welcome positive development. Rising input costs, particularly shipping fees, are a problem, but with transportation indices (such as the Baltic dry index) rolling over, margin pressures will ease. The bottom line is that the Canadian economy remains a coiled spring until the overhang of the Covid-19 crisis clears. Only then can the economy revert back to the high-beta status that has defined it for much of the last two decades. The BoC Will Stay Relatively Dovish Chart 7Is Canada Still A High-Beta Bond Market? Canada’s historical experience as a high-beta economy, leveraged to global growth momentum, has also translated into Canada having a high-beta government bond market (Chart 7).  Canadian bond yields are relatively more sensitive to movements in global bond yields, particularly during periods of rising yields that coincide with cyclical upswings in global growth.  That sensitivity has fallen during the pandemic, however, as the BoC has been forced into an extraordinarily easy monetary policy stance. This includes not only cutting policy rates to 0% but aggressively expanding its balance sheet through quantitative easing (QE) operations (Chart 8).  While the rate cuts matched the moves seen by the Fed and other major central banks, the BoC’s QE stands out among the others - measured on a year-over-year basis, the BoC’s balance sheet has grown by a stunning 350%! The BoC has needed to be that aggressive, given the extent of the pandemic-related economic downturn in Canada. According to our Central Bank Monitors - comprised of economic, inflation and financial variables that measure the pressure to adjust monetary policy – the BoC stands out as having the greatest need for accommodative policy settings (Chart 9). Looking at the sub-components of the BoC Monitor, the weakness is centered on the economic components. This suggests that there will be no pressure on the BoC to back away from the current extraordinarily accommodative monetary policy settings without a broader-based recovery in the Canadian economy. The bond market agrees with this assessment, discounting no change in interest rates over the next couple of years. The front end of the Canadian government bond yield curve has been anchored at extremely low levels, with the 2-year yield ranging between 0.15% and 0.35% since April 2020. Chart 8BoC Has Been Aggressive With QE Chart 9BoC Needs To Stay Accommodative, For Now Underwhelming inflation is another reason to expect a continued dovish policy bias from the BoC.  Headline CPI inflation was only 0.7% in December, below the BoC’s 1-3% inflation target band, after briefly dipping into outright deflation in the spring of 2020 (Chart 10).  The readings from the BoC’s preferred core inflation measures are not as depressed, with the median CPI inflation rate at 1.8%, just under the midpoint of the BoC target band. Chart 10No Imminent Inflation Threat In Canada A sustained upturn in inflation, however, is unlikely without a reduction in spare economic capacity.  The Canadian unemployment rate declined from a peak of 13.7% last May to 8.6% in December, but that remains well above most estimates of full employment.  The long-term unemployment rate is slowly inching higher, however, reaching 2.4% in December, up nearly 1.5 percentage points since May. This suggests that some of the temporary unemployment in lockdown-stricken industries is becoming permanent, a potentially worrying sign for future inflation pressures if Canada continues to struggle with the vaccine rollout. The BoC estimates that there is still ample capacity in the economy as measured by the output gap, which was at -5.8% in Q4/2020 using the central bank’s preferred method of estimating potential GDP.1 This is lower than the OECD’s estimate of the Canadian output gap, which is not projected to be fully eliminated until 2023. In its latest Monetary Policy Review published last month, the BoC noted that they project potential GDP growth to average only 1.4% between 2021 and 2023, 0.4 percentage points below the pre-pandemic estimate of trend growth. That reduction comes almost entirely from a lowered estimate of labor productivity growth resulting from the weakness in business investment spending combined with the growing permanent “scarring” effect on the Canadian labor force from the pandemic. Weaker potential growth implies that the long-run equilibrium interest rate must also be lower. The BoC now estimates that the neutral nominal policy interest rate is somewhere between 1.75% and 2.75%, a range that is 0.5 percentage points below the pre-pandemic level. This implies that the range for the neutral real rate is between -0.25% and +0.75% after adjusting for inflation using the midpoint of the BoC’s 1-3% target band. This is a significant drop in the equilibrium level of interest rates in response to the Covid-19 shock. By comparison, the NY Fed’s estimate of Canada’s neutral real rate (or “r-star”) was around 1.5% pre-pandemic (Chart 11).  Interest rate markets are pricing in an outcome at the low end of that range. The Canadian overnight index swap curve now discounts that the BoC will not begin raising rates until early 2023 and will raise rates very slowly thereafter, even with the central bank projecting a return to 2% headline CPI inflation by 2023 (Chart 11, middle panel). In other words, the market expects several years of negative real policy interest rates in Canada.  As a result, real yields from Canadian inflation-linked bonds are now below zero (Chart 11, bottom panel), even as inflation breakevens have been drifting higher. What could prompt the BoC to move to a less dovish policy bias and, potentially, a faster pace of monetary tightening than the market expects?  Obviously, good news on the vaccine rollout and a reopening of the locked-down parts of the Canadian economy would prompt the BoC to begin tweaking its policy settings in response to reduced uncertainty on growth.  This would start with a reduced pace of QE asset purchases, as BoC Governor Tiff Macklem noted at last month’s monetary policy meeting. Concerns over financial stability risks could also motivate the BoC to begin dialing back monetary accommodation. The plunge in longer-term interest rates has helped fuel another upturn in the Canadian housing market. The BoC’s housing affordability index is back down below the levels that predated the rapid surge in house prices during the previous decade (Chart 12, top panel).  House prices are increasing at nearly a 10% pace, with the uptrend likely to continue given the rise in the ratio of existing home sales to housing starts (Chart 12, middle panel). Chart 11BoC Policy Encouraging Negative Real Yields Chart 12Another BoC Fueled Housing Boom Given the BoC’s past focus on excessive valuations on Canadian housing in recent years, concerns that a new housing bubble had been triggered by overly accommodative monetary policy could prompt the BoC to begin dialing back QE or signal that rate hikes could come sooner than the market expects. Chart 13Fiscal Drag Expected In 2021 Additional fiscal stimulus could also change the BoC’s thinking on policy settings. The IMF’s estimate of the “fiscal thrust” (the change in the cyclically-adjusted primary budget balance) in Canada was massive in 2020, equal to 17.4% of potential GDP, as Canadian governments at both the federal and provincial level unleashed an arsenal of tools to fight the economic shock of the pandemic (Chart 13).  Far less stimulus is expected in 2021 as the Canadian economy reopens. However, the Canadian government did announce an additional C$70-100 billion in stimulus at the end of 2020 and has committed to maintaining fiscal support once the pandemic has ended.  That could be enough to prompt the BoC to begin tightening up monetary policy if fiscal policy is not reined in more quickly as the Canadian economy recovers and the Canadian output gap closes at a faster pace. Summing it all up, it seems likely that the BoC will maintain its current easy policy settings until well into the second half of 2021.  A faster than expected recovery in Canadian growth could trigger a move sooner than that, but it is highly unlikely that the BoC would turn less dovish before the US Federal Reserve for fear of causing a surge in the Canadian dollar. The BoC’s aggressive QE expansion has helped offset the potential tightening of Canadian financial conditions stemming from the loonie’s recent appreciation by holding down Canadian bond yields (Chart 14).  The BoC has room to do more, if necessary, if the CAD continues moving higher before the Canadian economy can handle more currency strength. Chart 14BoC QE Is Now A 'Defensive' Strategy There is a good chance that the Fed will begin signalling a tapering of its own QE bond buying towards the end of 2021.  We would expect the BoC to signal reduced QE fairly soon thereafter, especially as a Fed taper would likely only happen if the Covid-19 vaccine distribution was successful and the US economy was starting to return to normal. Investment Conclusions: Fixed Income Chart 15Canadian Bond Strategy Overview Our analysis of the Canadian economic, inflation and policy backdrop leads us to the following investment recommendations (Chart 15): Duration: Investors should maintain a moderately below-benchmark stance on Canadian duration exposure. Canadian yields will continue to drift higher over the next 6-12 months, even if the BoC maintains an aggressive pace of QE, on the back of a cyclical global economic upturn that will keep putting mild upward pressure on global bond yields. Country Allocation: We are sticking with our current neutral recommended allocation to Canadian government bonds in global fixed income portfolios, for now.  We are also placing Canada on “downgrade watch”, as the BoC will likely move faster than other central banks (except the Fed) to begin withdrawing policy accommodation if the vaccine rollout is successful and the Canadian economy recovers at a faster pace.  Yield Curve: We recommend positioning for additional steepening of the Canadian yield curve.  The front end of the curve will continue to be pinned down by the BoC maintaining dovish forward guidance on the timing of future rate hikes. At the same time, the longer end of the curve will continue to move higher on the back of rising inflation expectations in the near term and, potentially, a move to reduced QE later in 2020. Inflation-Linked Bonds: We continue to recommend dedicated bond investors favor Canadian Real Return Bonds over nominal Canadian government debt, despite less attractive valuations relative to mid-2020. 10-year inflation breakevens are still below the midpoint of the BoC’s 1-3% inflation target band, and will continue to creep higher – even if the CAD appreciates further - until the BoC signals a shift to less dovish policy. Investment Conclusions: CAD The key drivers of the Canadian dollar are what happens to natural resource prices, specifically crude oil, and the Bank of Canada’s monetary policy stance relative to the Federal Reserve. The fact that the BoC will fade any near-term improvement in the Canadian outlook suggests that interest rates will not be an important driver for the CAD/USD exchange rate, as we have witnessed recently (Chart 16). It also means that the CAD will underperform at the crosses, specifically vis-à-vis countries with central bankers likely to adopt a faster hawkish bias. At the top of this list is the Norges Bank. With very low rates globally, the currency correlation with yield differentials matters less. Instead, other factors, such as terms of trade (or relative equity market performance) will matter a lot more, as they have in recent months. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. Our commodity strategists predict that Brent crude will hit about $71 next year. This is much more than the forward markets are discounting. Rising forward prices have usually been synonymous with a higher CAD (Chart 17). Chart 16Currency And Interest Rates Diverge Chart 17Path Of Oil Prices Is Critical Meanwhile, currency markets react to net portfolio flows, and those into Canada have been improving. It may be a sign of bargain hunting by international investors (Chart 18). While awareness towards global warming and climate change are mainstream, energy stocks have been in a 12-year relative bear market, suggesting much of the bad news is in the price. Meanwhile, global energy stocks trade at a price-to-book discount of 60% and have a dividend yield of 5.3%. The relative performance of the Canadian equity market is very much correlated to the relative price trajectory of energy stocks, suggesting some measure of mean reversion is due (Chart 19). Chart 18Some Bargain Hunting In ##br##Canadian Assets Chart 19Energy (And Canadian) Stocks Are A Coiled Spring Finally, our fundamental intermediate-term model, which incorporates commodity prices, suggests that the loonie is much undervalued (Chart 20). This puts 80-82 cents within striking distance, above which the CAD could reach escape velocity. Meanwhile, the CAD also has upside against the euro, the Indian rupee, and the Turkish lira. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. In general, a strategy for playing oil upside is to be long a basket of energy producers versus energy consumers (Chart 21). Chart 20The CAD Is Undervalued Chart 21CAD Versus Oil Consumers While the outlook for oil is positive, Canadian players suffer from two hiccups: First, continued new fuel standards will reduce the need for Canadian crude, which is of a heavier blend, with a much higher sulfur content. This will widen the discount between Western Canadian Select (WCS) and light sweet crude. This is bad news for Canadian oil producers and the loonie. Second, pipeline capacity remains a major hurdle to getting Canadian crude to US refineries. This leads to a transportation discount for Canadian crude oil. The Enbridge Line 3 replacement is facing delays from the state of Minnesota (390K additional barrels). The Keystone XL pipeline, a major release valve for Canadian oil (830K barrels a day in capacity), was rejected by US President Joe Biden. The Trans-Mountain Expansion project (690K additional barrels), connecting Alberta to the Westridge Marine Terminal and Chevron refinery in Burnaby, is slated to be competed only by the end of 2022. All this could slash Canadian market share as global oil markets recover. Chart 22Remain Short CAD/NOK Netting it all out, we expect the rise in crude oil prices to $71 per barrel to more than offset a widening in the Canadian discount due to transportation bottlenecks. This will still provide upside for the Canadian dollar as terms of trade continue to improve. However, this also places short CAD/NOK trades in a sweet spot. While Canadian crude is likely to remain trapped in the oil sands for now, North Sea crude will face fewer transportation bottlenecks in the near term. This suggests that the path of least resistance for the CAD/NOK is down (Chart 22). As for AUD/CAD, we are neutral the cross near parity. On the one hand, as oil prices play catchup with the spectacular rise in metals prices, relative terms of trade favor the CAD. Last week, we went short the AUD/MXN cross on this basis. The improvement in the US economy, compared to the rest of the G10, also benefits Canada more. On the other hand, Australia is handling the Covid-19 crisis pretty well, suggesting the economy could achieve higher output growth much faster. In conclusion, the following trades make sense for the CAD: Long CAD/USD Long CAD/(EUR+TRY+INR) Short CAD/NOK Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The BoC’s preferred potential GDP measure is derived from the “integrated framework” method, which uses trend growth rates of labor and labor productivity to estimate trend GDP growth.

特別レポート

Highlights Volatility subsided but we still think geopolitical risk is underrated in the near term. The new Biden administration faces critical tests on China/Taiwan and Iran. The Biden-Xi phone call did not resolve anything. We recommend investors hedge geopolitical risk by adding a tactical long CHF-USD. The medium-to-long-term macro backdrop is shifting in favor of frontier markets – but it is too soon to dive in. African frontier markets have not yet benefited from the global economic recovery – and may face more pain in the near term. The Ethiopian crisis will further destabilize the Horn of Africa region. Kenya is the relative beneficiary in geopolitical terms, though Kenyan stocks are expensive relative to other frontier markets. Feature Volatility subsided over the past two weeks, global stocks rallied, and bond yields rose. The US dollar bounce lost some of its steam. From a macro point of view, we understand investor exuberance. But from a geopolitical point of view, risks are now understated. President Joe Biden faces imminent tests from China, Iran, and Russia. Table 1 provides a checklist of what we need to see to conclude that a new US-China modus vivendi has been established. The phone conversation between Presidents Biden and Xi Jinping on February 10 is marginally positive but, judging by history, the call shows that tensions remain high.1 Until these conditions are met the two sides are hurtling toward a diplomatic crisis over the Taiwan Strait sometime after China emerges from its annual National People’s Congress. Incidentally, China’s ongoing policy shift toward slower and more disciplined growth will be the takeaway from this year’s legislative session, which is not positive for global cyclicals or China plays beyond the near term. China’s credit impulse has decisively rolled over and the combined fiscal-and-credit impulse is peaking now (Chart 1). Table 1First Biden-Xi Call Did Not Resolve US-China Tensions Chart 1China's Fiscal-And-Credit Stimulus Peaking Now A crisis is also brewing in the Middle East. Iran is not going to abandon its quest for nuclear weapons over the long run but it is willing to negotiate a deal in the short run that reduces US sanctions. Especially if lame duck President Hassan Rouhani gets it done before he steps down in August. The next Iranian president will not want to make the same mistake Rouhani made and bet his future on the unreliable United States. This requires Biden to rejoin the existing 2015 nuclear deal with a vague commitment to negotiate a better deal later. However, this outcome is precisely what Israeli officials have called a “calamity.” 2 The Biden team gives Iran three-to-four months before it has enough highly enriched uranium to make a bomb – it wants to move quickly on negotiations. Israel gives it a year – it wants to convince the Democrats to stick with Trump’s maximum pressure. Either way the first half of this year is crunch time. Otherwise Iran’s new administration will require a much longer negotiation. Negotiations will be checkered with attacks to demonstrate credible threats and red lines. Ultimately, since we expect Biden to forge a US-Iran détente, and since the China/Taiwan risk is negative for energy prices, we no longer express our Iran view in the form of a long oil position. Brent crude is close to our Commodity & Energy Strategy’s $63 per barrel target for this year’s average. The Saudis could abandon their production discipline when Iranian oil gets closer to coming online. Investors should distinguish these immediate geopolitical risks from the general, long-running US-China and US-Iran conflicts. These will wax and wane while global risk assets grind upward over the long haul. If China avoids over-tightening policy and the Biden administration passes early hurdles we will be more bullish. For now we recommend investors hedge their bets by increasing exposure to safe-haven assets. We remain long gold and Japanese yen. Tactically we recommend going long the Swiss franc versus the dollar as well. Finally, in what follows, we take a sojourn from these headline geopolitical risks to offer a special report on the Ethiopian crisis and implications for Africa, Europe, and frontier markets. Now is not the right time to dive headlong into African frontier markets given the risks outlined above but we do see an opportunity on the horizon. Is The Ethiopian Crisis Investment Relevant? Ethiopia is now in its fourth month of crisis. The country is grappling with internal conflict brought upon by political and ethnic differences among the former and current ruling elite. Over the past week, Ethiopian Prime Minister Abiy Ahmed spoke with US Secretary of State Antony Blinken, French President Emmanuel Macron, and German Chancellor Angela Merkel about reports that Eritrean soldiers have entered the fray. East Africa will become increasingly unstable as conflict persists, threatening security, migration, and investment into the region. Investors looking to frontier markets in light of the global liquidity explosion should exercise caution. Peacemaking Abiy Goes On The Offensive Ethiopian government forces continue to battle a minority group, the Tigray People Liberation Front (TPLF), in the north of the country. Large-scale attacks, like those seen at the start of the conflict, have mostly diminished. However, both sides continue to maintain their offensive positions. With the recent entry of Eritrean forces into Ethiopia to support the government’s battle against the TPLF, conflict between government forces and the TPLF will continue at the very least. Tensions between the government of Prime Minister Abiy and the Tigray people have been in play for years. The Tigray largely dominated Ethiopia’s ruling coalition and security forces until the past decade. Public protests in 2015 were driven by frustration over laws that denied Ethiopians basic civil and political rights. In 2018, a popular uprising brought Abiy to power and he ushered in democratic reforms and an end to conflict with neighboring Eritrea. Abiy’s “reforms” are so far of limited relevance to investors. He released several high-profile political prisoners, lifted a draconian state of emergency, and planned to amend the constitution to institute term limits for prime ministers. Some civil liberties were restored. The investment-relevant aspect of the reforms were proposals to end government monopolies in key economic sectors, including telecommunications, energy, and air transport – but these have yet to happen. Abiy was most eager to dismantle Ethiopia's previous ruling party, the Ethiopian People's Revolutionary Democratic Front (EPRDF), which was dominated by the Tigray and had run the country for 28 years. Abiy supplanted the EPRDF with a single national Prosperity Party, which was not organized on ethnic lines. Having controlled all facets of state power prior to its ouster in 2018, the TPLF views Abiy’s democratic reforms and proposals for economic liberalization with anxiety. Abiy’s interest in reforming the federalist structure of the Ethiopian state - which divides Ethiopia into nine self-governing ethnic territories - threatens to undermine the order that has historically permitted the small Tigrayan ethnic group to wield a power disproportionate to its population (Chart 2). Chart 2Major Ethnic Groups In Ethiopia Abiy is an Oromo by origin and thus a member of Ethiopia’s largest ethnic group. His espousal of a broader nationalist agenda over narrow ethnic priorities is viewed by many of the smaller ethnic groups as eroding the right to self-rule. This includes secession, which is granted by the Ethiopian Constitution to ethnically organized regions. The TPLF has also expressed unease with Abiy over his intentions to amend the Constitution, which provides the basis of the current ethnic federalism. In defiance, the TPLF broke away from the Prosperity Party and attempted to unite opposition forces under a new federalist coalition. Failing to do so led the TPLF to isolate itself from the country’s political process. Bottom Line: As is often the case in geopolitics, the media hype about the election of a young peacemaker and would-be reformer masked the reality that Ethiopia’s old regime was coming apart at the seams. Abiy And The TPLF Faceoff Since 2019, Abiy has accused the TPLF of trying to destabilize the country and suggested that the TPLF were responsible for several mass ethnic killings across Ethiopia. Matters worsened in March 2020, during the collapse of the global economy amid the COVID-19 pandemic, when Abiy postponed national and regional elections scheduled for August, causing mass discontent among the TPLF. Abiy claimed he postponed the election because of the pandemic, citing the risks involved in mass in-person voting. But Tigray leaders feared a power grab. This is because the 2020 election was to serve as a litmus test on Abiy. Furthermore, opposition parties believe the Prosperity Party has achieved little economic policy cooperation and support among other parties, which would weaken the prospect of Abiy forming a coalition government if need be. In essence they hoped to claw back some power during the election and its deferral sent them into revolt. Relations soured further in September 2020 when the TPLF went forward with elections in Tigray, despite the rest of the country holding out for the delayed 2021 elections. The TPLF reported an overwhelming victory in the popular vote. The newly installed regional legislators in Tigray immediately declared that Abiy’s government lacked legitimacy to govern the country and refused to recognize it. The national assembly countered by annulling Tigray’s election results and refusing to acknowledge the newly elected leadership. Federal funding to the region was slashed significantly, limiting the flow of resources only to local governments to keep basic services running. The leadership in Mekele, the capital of Tigray, called the cessation of funding a declaration of war. Tensions boiled over into physical violence between government troops and the TPLF in November 2020. Widespread military attacks had been reported almost weekly between November and December often with many casualties of military personnel, TPLF members, and civilians. In 2021, attacks have significantly decreased, but TPLF resistance remains strong and intact in the North of the country. While the local economy was hard-hit by the fighting, it is not clear how long the local economy can sustain the state of resistance by both government forces and the TPLF. Bottom Line: Violence and war will continue between Abiy and the TPLF for the foreseeable future. Peace is hard to see happening at the current juncture, as Abiy looks to increase the power of his government and the TPLF fights to retain vestiges of its former power. Conflict Derails Economic Progress Ethiopia has averaged double-digit growth over the past decade, driven by large-scale fiscal spending and foreign direct investment. The country’s consumer base is also rising – 110 million people make the country the second most populous in Africa, with 50% of working age. But COVID-19 has put the brakes on future growth expectations, now penned at levels last seen in the early 2000s (Chart 3). Post 2021, growth is expected to rise significantly, but protracted mass social unrest brought about by internal conflict will see the economy grow at much lower levels. Offering a reprieve to the country’s economic woes is coffee bean production, Ethiopia’s chief export, which is mostly to the east of the country. Futures markets have priced in rising risk since the onset of the conflict. Transporting coffee beans would have to move through the north east of the country to the nearest port for export, in Djibouti. Moving through this part of the country raises the risk of encountering sporadic conflict. Chart 3Ethiopia Economic Growth Chart 4Horn Of Africa Output Per Head In 2000, Ethiopia was the third-poorest country in the world. More than 50% of the population lived below the global poverty line—the highest poverty rate in the world. Just two decades later, Ethiopia almost doubled GDP per capita wealth – a noteworthy achievement. But the country is still only comparable to Uganda, a much smaller, less developed economy to the southwest (Chart 4). Whilst income shared across the country has been rising, Abiy’s government runs the risk of eroding several years of economic gains that have been felt throughout the population by maintaining its battle against the TPLF. An economic crisis now would exacerbate the conflict and pull Ethiopia’s economy further into recession and poverty. Bottom Line: The Ethiopian conflict will persist in the coming years, resulting in the deterioration of many years of hard-earned economic development. The TPLF’s military and economic resources may be fast declining, but the conflict is domiciled on home ground – the Tigray region – and is widely backed by the Tigray people. International criticism is unlikely to deter Abiy from trying to minimize the TPLF’s political prowess. His popularity will allow him to keep his hard line. Yet Abiy will have to deal with an economy that will further decline as fighting continues. Regional Stability At Risk? The Horn of Africa is a gateway to the Suez Canal and as such a strategically important region. Its coastal opening on the Red Sea positions it along the critical maritime trade artery linking Europe and Asia. The Horn of Africa is also a fragile region that has seen severe conflict over the past decades: a civil war in Somalia and continued attacks by Al-Shabaab; piracy off the coast of Somalia; civil war in Darfur and South Sudan; proximity to the civil war in Yemen; ethnic unrest in Ethiopia; and the securitization of the Red Sea, as exemplified by Djibouti, which now hosts more foreign military bases than any other country in the world. Ethiopia is the African linchpin of the region’s long-term stability. The country runs a successful peacekeeping mission in neighboring Somalia. This will end if conflict with the TPLF continues to escalate. The country contributes around 4,000 of the 17,000 troops under the African Union’s mission and has around 15,000 additional soldiers in Somalia on its own — more than any other nation. If need be, troops will be pulled from Somalia to fight the TPLF, creating a security vacuum in Somalia where Al-Shabaab would revive. To make matters worse, US troops began withdrawing from two bases in Somalia in October. Though former President Trump failed to pull all US troops from the country, and President Biden is ostensibly in favor of maintaining US global engagement, it remains to be seen whether the US will put real pressure on Ethiopia to halt the conflict, such as threatening to cut its roughly $1 billion in annual aid. Many of the 700-odd US forces in Somalia train and support Somali special forces (Danab), who seek to contain the Al-Shabaab insurgency. Considering that Al-Shabaab has carried out deadly attacks on civilians throughout the East African region, such as the Westgate shopping mall attack in Kenya eight years ago and an attack on a US military base in Kenya that killed 3 Americans in January 2020, terrorism will pick up if regional security efforts are reduced. Bottom Line: Neither Ethiopia nor international terrorism are high on the Biden administration’s list of things to do. At home Biden is focused on domestic legislation to handle the pandemic and economic recovery. Abroad he is focused on restoring the 2015 Iranian nuclear deal and countering China’s and Russia’s regional ambitions. The Europeans, for their part, will react with lukewarm punitive economic measures toward Ethiopia, as they are not wishing to destabilize the region any further. Migration Will Follow After Conflict For global investors a more pertinent concern may be the rise in displaced persons, asylum seekers, and refugee populations in the region. At the end of 2019, Sub-Saharan Africa had 16.5 million internally displaced persons and 6.5 million refugees. Of this, the Horn of Africa hosts 8.1 million internally displaced persons and 4.5 million refugees and Ethiopia hosts 1.7 million displaced persons and 700,000 refugees. Note that these numbers come from the year before Ethiopia’s tensions boiled over – Ethiopian refugees will surge in 2020-21. In terms of migrants outside of Africa and originating from Ethiopia, there were 170 000 refugees and asylum seekers at the end of 2019 (Chart 5). Refugees, asylum seekers, and displaced persons will multiply as conflict rages. Neighboring countries like South Sudan, Sudan, Eritrea, and Somalia, which are already stretched in their capacity to hold such persons, will be overwhelmed. Already, these four countries alone account for approximately 4.4 million refugees, making up more than half of Africa’s total number of refugees (Chart 6). While Ethiopia’s contribution to the continent’s migrant base (both refugees and asylum seekers) is small (2.2%) in comparison to its neighbors, it is this very reason that suggests destabilization will add significant numbers to the growing crisis on the continent. Chart 5Ethiopian Refugees And Asylum Seekers Chart 6African Refugees And Asylum Seekers Europe and the Middle East are the two preferred regions for Ethiopian migrants. Europe received approximately 22% of Ethiopian-born refugees and asylum seekers in 2019, again, prior to the outbreak of civil war (Chart 7).   Chart 7Ethiopian And African Refugees In The EU With reports suggesting that an additional 600,000 displaced persons have emerged due to this year’s conflict, and another 40,000 refugees, the EU could see an additional 10,000 migrants from Ethiopia alone over the next year. On top of that would be counted any increase in refugees and asylum seekers resulting from increasing instability in the Horn of Africa. A more intense conflict will drive the numbers up dramatically. Bottom Line: The effects resulting from conflict in the region’s most populous and stable economy will carry over into neighboring countries, such as Somalia, exacerbating the refugee and economic crises in the Horn of Africa and ultimately increasing the risk of greater immigration into Europe. In comparison to the Syrian refugee crisis, Ethiopia is not in a state of utter collapse like Syria but if it did collapse it would pose a larger risk to Europe. Ethiopia’s population is four times larger than that of Syria’s in 2011. Syria counted 6 million internally displaced persons and almost 5 million refugees (approximately 25% of the population) at the start of the civil war. From the 5 million refugees, 2% made their way into Europe. A civil war of a similar magnitude in Ethiopia would result in almost 28 million refugees (25% of 110 million population), and 600 000 refugees heading toward Europe, by the same metrics. Surrounding Markets Will Benefit From Re-Directed Investment Direct investment flows from the country’s primary benefactor, China, have helped to spur Ethiopia’s growth and development. The country has received approximately 67% of all Chinese direct investment funds into the Horn of Africa since 2005 and 8% of the total in Sub-Saharan Africa (Chart 8). Chart 8China Slows Investment In Africa The trend has turned down over the past couple of years, with Chinese officials citing over-exposure to Ethiopia as a reason for lower outward investment into the country. In this sense China appears to have recognized a growing problem in Ethiopia in recent years. Infrastructure projects such as the Addis Ababa-Djibouti railway have resulted in large losses for Chinese firms due to insecurity and liability risks. For example, parts of railway have at times been rendered inoperable due to infrastructure theft or sabotage, or by intentional accidents by civilians to claim liability against the railway line’s constructor and operators. Rising conflict in Ethiopia will squeeze Chinese interests out of the country and redirect them to more stable markets, such as Kenya, to expand its Belt and Road Initiative along the East African coast (Chart 9). Kenya has at times received more direct investment from China than Ethiopia. China’s various problems with investment projects in Kenya pale in comparison to Ethiopia’s general instability. A nudge toward a more sustained flow of funds to Kenyan projects is now on the horizon. China could build further economic interest in neighboring Uganda but political risk continues to rise in the country after a contested election saw the country’s ruler for the past 35 years, Museveni, win his sixth term in office. The same holds for other foreign investment flows into Ethiopia. On a net basis, foreign direct investment into Ethiopia has been declining since 2016, while neighboring Uganda and Kenya have recorded upticks over the same period (Chart 10). Chart 9China’s Investment In East Africa Chart 10Kenya And Uganda Will Get More Investment Bottom Line: Foreign direct investment into Ethiopia and the region has been declining, even from China and even prior to the 2020 crisis. Investors and foreign flows will look to relatively more stable markets, such as Uganda and Kenya, to take on longer-term risk. Where To From Here? The longer Abiy drags out military operations, the likelier the Tigray conflict could metastasize into an humanitarian crisis and ultimately civil war. While political survival is at the forefront of Abiy’s considerations, he has broadly staked his international reputation on being a reform-minded innovator who will usher in needed change to Ethiopia. A key question is whether Abiy will now move to de-escalate the conflict – to bring military operations to a close and turn his attention to reconciliation. The Ethiopian army’s convincing victory in Mekelle provides Abiy with a valuable off-ramp to enter negotiations and pivot back to his reform agenda. If Abiy does not take advantage of this moment, he risks undermining Ethiopia’s fledgling economy, fostering a prolonged humanitarian crisis, getting stuck in a protracted armed conflict, and destroying his international reputation. The EU has already delayed payment of 90 million euros in aid in the wake of the conflict, and is threatening to withhold more from the 2 billion euro aid package that the EU agreed to disperse to Ethiopia over several years. However, at present, Abiy remains defiant, stating that the offensive toward the TPLF is warranted and arguing that Ethiopia’s sovereignty is not “for sale” to international donors. Abiy will continue to put pressure on the TPLF unless they concede to federal supremacy. As the larger force in this battle, Abiy’s government will not back down. He has the backing of the military and neighboring forces such as the Eritrean military. His popularity has remained intact through the course of this latest conflict. With an upcoming national election, he is looking at the conflict as a way to consolidate control. Bottom Line: Abiy has the political capital to wait out the TPLF’s surrender, while the economy takes a knock from ongoing conflict. Investment Takeaways A major wave of immigration from the Horn of Africa into Europe would not have predictable financial consequences. The Syrian refugee crisis, which peaked in 2015, did not have a discernible impact on the Turkish lira, or Greek, Italian, or Turkish relative equity performance. It might have contributed to investor preference for the dollar over the euro but the real driver of euro weakness at that time stemmed from the European Central Bank’s quantitative easing and US relative growth and interest rates. A bounce in USD-EUR during the spike in refugees in mid-2016 cannot be attributed to interest rate differentials but it is brief (Chart 11). Thus the significance of any major wave of immigration in the post-COVID era will be found elsewhere – in politics and geopolitics. Chart 11Syrian Refugee Crisis A Political, Not Financial Event The geopolitical consequence of the Syrian refugee crisis was ultimately a rise in European populism or anti-establishment politics. The political establishment mostly blunted this trend by cracking down on migrant inflows. That could change in future if border controls are relaxed or the magnitude of migration increases. Falling GDP per capita in Africa over the past decade alongside superior quality of life in Europe will continue to motivate immigration, especially if Africa’s growth disappoints expectations in the aftermath of the crisis (Chart 12). Conflicts such as in Ethiopia will generate more emigration. What about African frontier markets? Ostensibly the global backdrop is as bullish for frontier markets and specifically African frontier markets. Valuations are deeply depressed after a decade of strong dollar and weak commodity prices. Now global central banks are flooding the world with liquidity, the dollar is falling, and commodity prices are rising. China, Europe, and the US have stabilized their economies. However, it should be noted that Sub-Saharan Africa’s exports have lagged and therefore the economic pain is not yet over for this region even though improvement is on the horizon (Chart 13). If growth returns to trend then Sub-Saharan Africa’s real GDP should grow in line with emerging markets at a little less than 5% per year. This is better than Latin America, which also has a slightly smaller stock of gross domestic savings, though both regions are savings-poor and struggling to form fixed capital. Chart 12Disparity Between Europe And Africa Chart 13Global Commodity Prices And African Exports Soaring Chart 14Sovereign Credit Spreads Emerging and frontier markets stand to benefit from low global interest rates and rising commodity prices but they need to see global economic stabilization first. Sovereign credit spreads have come down across the frontier markets, with African markets leading the way (Chart 14). However, debt levels are high in a number of these markets. Credit default swap rates are rising after their steep fall over the second half of last year (Chart 15). Emerging market equities have rallied sharply relative to developed markets and this trend should continue as the pandemic subsides and the global recovery gains steam. But frontier markets have underperformed emerging markets since mid-2019 and South Africa specifically since COVID-19, with no sign yet of reversing. Within frontier markets, African equities have outperformed since the first vaccines heralded a recovery in the global economy (Chart 16). Chart 15Credit Default Swaps The COVID-19 crisis has affected emerging and frontier markets differently than developed markets given that youthful populations are least susceptible to dying from the disease. However, the economic impact has required monetary easing and currency depreciation. EM and FM central banks have undertaken unprecedented and unorthodox easing actions – similar to what is seen in the developed world – to cushion the blow. Chart 16Emerging Markets Vs Frontier Markets Vs African Markets Not only have EM and FM central banks cut rates but they have also cut reserve requirements for banks, intervened in foreign exchange markets, and launched government bond purchases. South Africa has begun quantitative easing while Ghana has monetized debt. Table 2 provides a glimpse at equity performance, volatility, and relative valuations and momentum in frontier markets, including African frontier markets. Returns are paltry over the course of the COVID-19 crisis. African markets have generated a negative return during this period. The table shows valuations and momentum on a relative basis – that is, relative to other markets in the table. We include South Africa, a major emerging market, by comparison to indicate that frontier markets are not necessarily more volatile even though they are far cheaper. All of these stocks other than South Africa are cheap on a price-to-earnings basis and African markets look even better on a cyclically adjusted P/E basis. Table 2African Frontier Markets: Valuations, Momentum, Volatility Chart 17Hold Off From Frontier Markets Nigerian stocks are extremely cheap, they have benefited from the recovery in global oil prices, and they offer half as much volatility as South African stocks. They are even cheap relative to other African frontier markets like Kenya. However, the geopolitical situation is not stable. An incident of brutality from security forces last year did not lead to wider spread social unrest but the rapid growth of the population combined with the resource curse is not favorable for socio-political stability over the long term. Even in the short term Nigeria’s rally could be upset by a reversal in oil prices, which is possible if OPEC 2.0 fails to coordinate in the face of the eventual US-Iran deal. Moreover capital controls make risks excessive for most investors, as our Emerging Markets Strategy observes. Kenya is a geopolitical beneficiary of the Ethiopian crisis. It should receive greater foreign direct investment as a result of Ethiopia’s destabilization. However, this crisis is not a driver for Kenya’s equity markets. Rather, Kenya trades in line with the trade-weighted dollar. It is not a commodity play but a telecoms play. This has been a huge benefit over the past decade. Kenya is diversified and has a large manufacturing sector. It will eventually benefit from a revival of tourism. Kenyan stocks are cheap from a global point of view but not relative to frontier markets. The long-term trend of Kenyan stocks is flat whereas most African equities are falling (Chart 17). Our Emerging Markets Strategy team has highlighted that conditions will improve in the wake of material currency depreciation. From a tactical standpoint now is not the best time to dive into frontier markets or African frontier markets but an opportunity is around the corner. African exports have not recovered, several countries are pursuing monetary easing (thus weakening currencies), the US dollar is bouncing, and China’s credit impulse is rolling over. But the long-term global trends are supportive as long as China avoids over-tightening, interest rates stay low, and the dollar resumes its weakening path as we expect. Therefore we will devote more attention to frontier opportunities going forward as they offer the attraction of large capital gains and diversification.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Footnotes 1 The absence of a Biden-Xi call would have been market-negative but the call itself does not suggest that tensions have declined yet. The American account shows Biden lecturing Xi Jinping. He kept the Trump administration’s language regarding a "free and open Indo-Pacific," chastised Xi for "coercive and unfair economic practices, crackdown in Hong Kong, human rights abuses in Xinjiang, and increasingly assertive actions in the region, including toward Taiwan." Cooperation will be "results-oriented" and based on the "interests" of the US. All of this, in diplomatic language, is fairly tough. The Chinese account consisted of Xi giving Biden an even longer lecture about the importance of cooperation over confrontation, equality of nations, and non-interference in domestic affairs, including core interests like Hong Kong, Xinjiang, and Taiwan. See "Readout of President Joseph R. Biden, Jr. Call with President Xi Jinping of China," the White House, February 10, 2021, whitehouse.gov; and "Xi speaks with Biden on phone," Xinhua, February 11, 2021, Xinhuanet.com. 2 See Yoav Limor, "IDF Crafting New Options To Counter Iranian Threat," Israel Hayom, January 14, 2021, israelhayom.com.

Highlights For the month of February, our trading model recommends shorting the US dollar versus the euro and Swiss franc. While we agree a barbell strategy makes sense, we would rather hold the yen and the Scandinavian currencies. In the near term, we recommend trades at the crosses, given the potential for the dollar rally to run further. An opportunity has opened up to short the AUD/MXN cross. We are tightening the stop on our short EUR/GBP position to protect profits. We believe EUR/CHF still has upside. While the US has been labelling Switzerland  a currency manipulator, the real culprit is Europe. Precious metals remain a buy. We are placing a limit sell on the gold/silver ratio at 70, after our initial target of 65 was touched. Platinum should also outperform in 2021. Remain long AUD/NZD, as the key drivers (relative terms of trade and cheap valuation) remain intact. Feature Currency markets are at a crossroads. On the one hand, news on the vaccine front continues to progress, raising the specter that we might return to normalcy sometime in the second half of this year. On the other hand, the current lockdowns are slowing down economic activity across the developed world, which is bullish for the dollar. With the DXY index up 1.4% this year, it appears near-term economic weakness is dominating the currency market narrative. Our long-term trade basket is centered on a dollar-bearish theme, but we have been shifting much focus in the near term to non-US dollar opportunities. Central to this has been our conviction that the dollar is due for a countertrend bounce, in an order of magnitude of 2%-4%.1 It appears we are already halfway there (Chart I-1). For the month of January, our trade recommendations outperformed the model allocation. Notable trades were being short gold versus silver and being short EUR/GBP. Silver in particular was a big winner in January (Chart I-2). Most emerging market currencies saw weakness, especially the Korean won, Russian ruble, and Brazilian real Chart I-1The Dollar Has Been Strong In 2021 Chart I-2Our FX Portfolio Did Well In January For the month of February, our trading model recommends shorting the US dollar, mostly versus the euro and Swiss franc (Chart I-3 and Chart I-4). The model gets its signal from three variables: Relative interest rates (both levels and rates of change), valuation, and sentiment.2 While some of these variables have moved in favor the dollar, the magnitude of these moves has not been sufficient to trigger a model shift. We agree a barbell strategy makes sense. That said, we would rather hold the yen (as the safe haven, compared to the CHF) and the Scandinavian currencies (compared to the EUR). These are our two strategic positions, and we made the case for yen long positions last week. Chart I-3Our FX Model Remains ##br##Short USD... Chart I-4...Especially Versus The Euro And Swiss Franc Circling back to our trades at the crosses, we maintain that they should continue to perform well in February and beyond. We revisit the rationale behind these trades, as well as introduce a new idea: Short the AUD/MXN cross. Go Short AUD/MXN A tactical opportunity has opened up to go short the AUD/MXN cross. Central to this thesis are three catalysts: relative economic activity, valuation, and sentiment. The Australian PMI has rebounded quite strongly relative to that in Mexico, driven by the performance of the Chinese economy, versus that of the US economy. Australia exports mostly to China, while Mexico is heavily tied to the US economy. With the Chinese credit impulse rolling over, the US economy has been outperforming of late. If past is prologue, this will herald a lower AUD/MXN exchange rate (Chart I-5). Correspondingly, oil prices are outperforming metals prices. China is the biggest consumer of metals, while the US is the biggest consumer of oil. A higher oil-to-metal ratio is negative for AUD/MXN. Terms of trade between Australia and Mexico have been an important driver of the exchange rate (Chart I-5). China had a massive restocking of metals last year, much more than oil and natural gas. This implies that the destocking phase (should it occur) will be most acute among metal inventories (Chart I-6), suggesting oil imports into China could fare better than metals. On a real effective exchange rate basis, the Aussie is expensive relative to the Mexican peso. Historically, this has heralded a lower exchange rate (Chart I-7). Chart I-5AUD/MXN And Terms Of Trade   Chart I-6Chinese Destocking: From Crude Oil To Metals? Chart I-7AUD/MXN Is ##br##Expensive Back in 2020, when everyone was short the Aussie and long the MXN, being a contrarian paid off handsomely. Now, speculators are roughly neutral both crosses. Should the trends we are highlighting carry on into the next few months, this will be a powerful catalyst for speculators to jump on the bandwagon. We recommend opening a short AUD/MXN trade today, with a stop loss at 16.50 and an initial target of 13. Stay Short EUR/GBP Chart I-8An Asymmetry In Pricing Our short EUR/GBP position is performing well, amidst a more hawkish Bank of England this week. Technically, there remains room for much downside on the cross. Real interest rates in the UK are rising relative to those in the euro area. The Brexit discount has not been fully priced out of the EUR/GBP cross, whereas broad US dollar weakness has eroded the discount in cable (Chart I-8). From a technical perspective, speculators are still very long the EUR/GBP, even though our intermediate-term indicator is nearing bombed-out levels (Chart I-9). Chart I-9EUR/GBP Still Has Downside Finally, short EUR/GBP tends to benefit from an outperformance of oil prices. We will be revisiting the fair value of the pound in upcoming reports given the fundamental shifts that are happening in the post-EU relationship. For now, we are tightening stops on our short EUR/GBP position to 0.89, in order to protect profits. Remain Long NOK And SEK Chart I-10NOK Follows Oil Prices The Scandinavian currencies are  extremely cheap and an attractive bet for 2021. As such, we believe the recent relapse in their performance provides an opportunity for fresh long positions. For the NOK, a rising oil price is bullish, both against the EUR and USD (Chart I-10). Meanwhile, superior handling of the pandemic has buoyed domestic economic data in Norway. Both retail sales and domestic inflation have been perking up, pushing the Norges Bank to dial forward expectations of a rate lift-off. Sweden is also holding up relatively well this year. Part of the reason for this is that over the years, the drop in the Swedish krona, both against the US dollar and euro, has made Sweden very competitive. With our models showing the Swedish krona as undervalued by 13% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. The bottom line is that both Norway and Sweden are well positioned  to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to remain the best performers versus the USD in the coming year.  Stay Long EUR/CHF While the US has been labelling Switzerland  a currency manipulator, the real culprit is the euro area. To be clear, the SNB has been actively intervening in the currency markets. However, when one looks at relative monetary policy, the expansion in the ECB’s balance sheet far outpaces that of the SNB (Chart I-11). With the correlation between balance sheet policy and the exchange rate shifting, it may embolden Switzerland to intervene even more strongly in currency markets. Historically, the Swiss franc was buffeted by the global environment (improving global trade) and rising productivity in Switzerland. As a result, the SNB had no alternative but to try to recycle those excess savings abroad by lifting its FX reserves, or see even stronger appreciation of its currency. With global trade much more muted, intervention in the FX market could be a more potent headwind for the franc. Chart I-11The SNB Is More Hawkish Than The ECB Chart I-12EUR/CHF And The Global Cycle In the near-term, the risk to this trade is that safe-haven flows  reaccelerate, as investors re-price risk. However, this will be a short-term hiccup. EUR/CHF is a procyclical cross and will benefit from improvement in the Eurozone economy relative to the rest of the world (Chart I-12). Meanwhile, by many measures, the Swiss franc remains expensive versus the euro. Stay Long AUD/NZD Chart I-13RBA QE Will Hurt AUD/NZD The rally in the kiwi has provided an exploitable opportunity to lean against it. We remain long the AUD/NZD cross, despite the RBA stepping up the pace of QE at its latest meeting. The rationale is as follows: The balance sheet of the RBA was already lagging that of the RBNZ, so the latest move is simply  catch up (Chart I-13). It has no doubt been negative for the cross, as Australia-New Zealand rates have compressed. However, when the program expires, the AUD will be subject to external forces once again.  The Australian bourse is heavy in cyclical stocks, notably banks and commodity plays, while the New Zealand stock market is the most defensive in the G10. Should value outperform growth, this will favor the AUD/NZD cross. The kiwi has benefited from rising terms of trade, as agricultural prices have catapulted higher. Should a correction ensue, as we expect, this will favor NZD short positions. Our conviction on long AUD/NZD has clearly been hit with the RBA’s latest move. As such, we are tightening stops to 1.05 for risk management purposes. Stay Long Precious Metals, Especially Silver And Platinum We are placing a limit sell on the gold/silver ratio at 70, after our initial 65 target was hit. The rationale for the trade remains intact: In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. However, silver has underperformed the rise in gold. The long-term mean for the gold/silver ratio is 50, providing ample alpha for this trade (Chart I-14). Chart I-14The Case For Short Gold Versus Silver Silver is heavily used in the electronics and renewable energy industries, which are capturing the new manufacturing landscape. Silver faced resistance near $30/oz. However, this will be a temporary hiccup. The next important level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange Strategy report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights US inflation expectations will continue to grind higher as commodity markets tighten, and financial markets price to an ultra-accommodative Fed over the next 2-3 years. The US stock-market rally is reducing equity yields and squeezing equity risk premiums, which acts as a drag on gold prices.  Higher earnings, lower stock prices or both are needed to reduce this effect. Pandemic uncertainty continues to fuel safe-haven demand for the USD, which remains a headwind for gold and silver.  Vaccination availability needs to reach a level that convinces markets global contagion risk has been minimized.  Until then, this remains the dominant downside risk to gold and commodities. The balance of risks continues to favor gold: US real rates will remain weak as the Fed remains behind the inflation-vs-rates curve, and the USD will be pushed lower (Chart of the Week).  We continue to expect gold prices to push to $2,000/oz. We remain bullish silver, and view the recent retail-spec price blip as transitory.  Fundamentally, silver supply growth is weakening, and demand is strengthening as the renewable-energy buildout accelerates and consumer spending revives.  We expect silver's price to trade back to $30/oz.  Feature US inflation expectations will continue to grind higher, as tightening markets for industrial commodities push oil and base metals prices higher (Chart 2).1 As is apparent in Chart 2, these real-economy factors feed directly into five-year inflation expectations, which are important to policy makers and portfolio managers managing risk in trading markets.2 Continued Fed accommodation of massively expansive US fiscal policy also will stoke inflation expectations, and keep real rates negative or weak at low positive levels as realized inflation and inflation expectations increase. These real and financial effects will be positive for gold prices, as the Chart of the Week illustrates. Chart of the WeekRising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Chart 2Tightening Commodity Markets Push Inflation Expectations Higher Battling against this tailwind is the historic US equity rally, which has crushed stock yields and the equity risk premium vs bond yields.3 Gold prices are positively correlated with equity risk premiums – the positive economic forces that push dividend yields higher also tend to push gold and commodity prices higher – which means the falling risk premiums are acting as a headwind to gold prices (Chart 3).4 If, as the global economy recovers, the rate of growth in earnings is greater than that of equity prices, stock yields will expand, which will be supportive of gold prices. That said, we do not expect the contraction of the equity risk premium to dominate the evolution of gold prices. Tightening fundamentals in the real economy and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics. Chart 3Falling Stock Yields Pressure Equity Risk Premiums Balance of Risks Favors Gold Fed policy pronouncements point to continued accommodation of massive fiscal stimulus in the US, with the central bank strongly indicating it will, as a matter of policy, remain behind the inflation-vs-rate-hikes curve for at least another 2-3 years. Taking the Fed at its word, this means US real rates will remain weak, and the USD will be pushed lower as the central bank continues to accommodate higher US budget deficits at the federal level. However, as we have repeatedly noted, the broad trade-weighted USD has found strong support at current levels following a precipitous fall from its COVID-19-induced highs in 1Q20: As pandemic uncertainty feeds into global policy uncertainty, USD safe-haven demand remains elevated (Chart 4).5 While we concentrate on five-year inflation expectations in our modeling, indications of price pressures are showing up in the manufacturing sector in the US (Chart 5), as our colleagues in BCA Research’s US Bond Strategy note in their report this week.6 This confirms that the price strength seen in commodity markets for raw materials used in manufacturing are showing up in the economy as a whole. Chart 4Lower USD, Stronger GDP Bullish For Copper Prices Chart 5Inflation Indicators Hook Up Our price target for gold remains $2,000/oz. The sooner vaccines are deployed globally – so that markets can reasonably assign lower odds to a resurgence of COVID-19 and its more insidious variants forcing new lockdowns – the sooner the pandemic uncertainty keeping the USD well bid will dissipate as a fundamental factor restraining a continuation of gold’s rally. Silver Is Not GameStop The Reddit-powered surge in retail silver trading this past week, which lifted silver prices some ~ 11% on Monday to $30/oz, is all but a memory now that the white metal is again pricing in line with fundamentals. We turned bullish silver in July of last year, arguing fundamentals suggested silver could outperform gold in 2H20, which it did.7 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 6). We expect the supply side of the market to remain under pressure this year and the next, given the physical deficits we are forecasting for the copper market over the next two year: The supply side of silver is a function of copper, zinc and lead mine output (i.e., silver largely is a byproduct). On the demand side, continued recovery of consumer spending and the decade-long buildout of renewable-energy generation – which is heavily reliant on copper and silver to a lesser degree – will force prices higher. We remain bullish silver. However, given our expectation its price will trade again to $30/oz, we do not expect any dramatic tightening of the gold/silver ratio this year (Chart 7). Chart 6Silver Market Tightens, Along With Other Commodities Chart 7Expect Gold/Silver Ratio To Continue To Narrow Bottom Line: Tightening commodity fundamentals and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics this year and the next. The contraction of the equity risk premium will not dominate the evolution of gold prices. At the margin, if earnings growth exceeds  equity-price increases, equity yields will expand, which will support gold prices. We expect gold and silver to trade to $2,000/oz and $30/oz this year – i.e., close to ~ 10% gains for both. Therefore, we do not expect much movement in the gold/silver ratio this year   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0’s Joint Technical Committee (JTC) lowered its estimated demand growth for 2021 to 5.6mm b/d from its 5.9mm b/d estimate last month, at its Tuesday meeting. The JTC also is expecting the oil market to be in a deficit this year, which will, by the Committee’s estimate, peak at 2mm b/d in May 2021, according to reuters.com. This is in line with our maintained hypothesis that the producer coalition led by Saudi Arabia and Russia will continue to calibrate production in line with demand to keep global storage levels drawing. The JTC was not expected to recommend any change in production policy to oil ministers on Wednesday when they met. We expect OECD oil inventories to hit their rolling five-year average in 1H21, largely because of OPEC 2.0’s production discipline and production losses outside the coalition (Chart 8). Base Metals: Bullish Battery-grade lithium carbonate soared 40% y/y in January in China to $9,450/MT, according to mining.com. The reporting service noted strong demand for lithium iron phosphate (LFP) batteries used to power subsidized short-range autos, public transport infrastructure electrification, and power generation. Precious Metals: Bullish COVID-19-induced demand destruction pushed gold demand down 14% y/y in 2020, to just under 3,760 tons, according to the World Gold Council’s 2020 supply-demand tallies.  At 4,633 tons, gold supply lost 4% y/y, the most since 2013, according to the WGC.  Supplies were disrupted by COVID-19 as well.   (Chart 9). Ags/Softs: Neutral Despite poor weather conditions in South America, US farmers are beginning to worry about record or near-record crops in the current growing season, according to farmprogress.com. grains are trading lower following recent rallies on concerns the upcoming harvest could be better than expected. Tomorrow’s USDA WASDE report will be eagerly awaited for the Department’s latest assessments. Chart 8OPEC 2.0 Keeps Supply Growth Below Demand Growth Chart 9Gold Below 200 Day Moving Average     Footnotes 1     Our most recent reports on copper and oil prices – Copper's Supply Challenges and Brent Forecast: $63 This Year, $71 Next Year published 10 December 2020 and 21 January 2021 – highlight the tightening of industrial-commodity markets globally. 2     While we do find strong relationships between gold prices and 5- and 10-year US real rates, we do not find any relationship with the slope of the US rates forward curve. 3    For a discussion of equity risk premiums, please see Asness, Clifford S. (2000) “Stocks versus Bonds: Explaining the Equity Risk Premium.” Financial Analysts Journal. March/April 2000: pp. 96-113. 4    In the post-GFC period 2010-2020, the S&P 500 equity risk premium is borderline insignificant in a cointegrating regression that includes other real and financial variables (i.e., copper prices, US Fed Funds, and global economic policy uncertainty). We therefore to not treat it as determinant to the evolution of gold prices in the same way as the real and financial variables we use as regressors. 5    We expect this pandemic uncertainty to break, but not until markets are convinced sufficient supplies of vaccines will be available globally to control COVID-19 infections, hospitalizations and deaths. Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, which we published last week, for further discussion. It is available at ces.bcaresearch.com. 6    For the first time 2011, the Prices Paid component in last month’s ISM Manufacturing PMI came in above 80, signaling for the first time since 2011. Please see No Tightening In 2021, published by BCA’s US Bond Strategy 2 February 2021. It is available at usbs.bcaresearch.com. 7     Please see Silver Likely Outperforms Gold In 2H20, which we published 2 July 2020. It is available at ces.bcaresearch.com. We recommended a long silver position then at $18.51/oz and closed it 23 September 2020 at $26/oz. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades