Commodities & Energy Sector

Special Report

Highlights We update our assumptions for the likely 10-15 year return for a wide range of different asset classes. Our methodology is basically unchanged from our last Return Assumptions report published in 2019, though we have refined our analysis and use of data in some areas. Returns over the next decade will be very low compared to history. We project that a standard global portfolio (50% equities, 30% bonds, and 20% alternatives) will return only 3.0% a year in nominal terms. That compares to a historic return of 6.3%. There are still some assets that will produce better returns, most notably small caps (4.9% a year in the US) and alternatives (6.2% for private equity, for example). But they also carry higher risk. Spreadsheets are available with detailed data. Introduction This is the third edition of our work on return assumptions. Since publishing the previous reports in November 2017 and June 2019, we have had many opportunities to discuss our methodologies with clients and in the Global Asset Allocation course at the BCA Academy. This has allowed us to test and, in many cases, refine our approach. We believe the methodologies we use have stood the test of time. We have always emphasized that this sort of capital markets assumptions (CMA) analysis is an art, not a precise science. We continue to prefer to project returns over a somewhat undefined 10-15 year period, since this allows us to think about the underlying trend of likely returns. Many other CMA papers use five (or even three) year time horizons which, in our view, are problematical since they rely heavily on a forecast of the timing, length, and severity of the next recession. Our approach is based on the concept that the return on the risk-free long-term government bond is the cornerstone to projecting asset returns, and that this return is rather predictable: It is approximately the current yield. Most other asset returns can be built up from that – the return on high-yield bonds, for example, by assuming that their historic spread over government bonds, and default and recovery rates will continue in the future. For equities, we continue to use six different methodologies, which are based on a mixture of valuation and projected earnings growth. This approach – that assumed returns can be built up from a combination of current yield plus forecast future growth in capital values – also works for most alternative asset classes, for example real estate. We have made a few minor changes to our methodology in this edition. We have, for example, made our use of historical data (for spreads, profit margins, growth relative to GDP, etc.) more consistent, using the 20-year average where possible. The biggest change this time is that clients can download here a spreadsheet with all the data in this report in order, for example, to use the data as inputs into their own optimizers. In addition, we have set up our detailed spreadsheet to allow clients to see the underlying inputs, the formulae behind our methodologies, and to input their own assumptions. This will also allow us to update the results of our analysis as often as needed. Please let us know here if you would like more details about this additional service. This Special Report is structured as follows. First, we analyze the overall results: What is the probable return from each asset class over the next 10-15 years, and how do these differ from historical returns. Next, we describe in detail the methodologies we use, for (1) economic growth, (2) fixed-income instruments, (3) equities, and (4) 12 different alternative asset classes. Then, we describe our way of forecasting currency returns, and show the return assumptions in different base currencies. Finally, we update the numbers for volatility and correlations, which many investors need as inputs into optimization programs. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in US dollars). The data is updated to end-April 2021 (except for some alternative asset classes where only quarterly data is available). Table 1BCA Assumed Returns Overall Results Returns over the coming decade are likely to be very disappointing compared to history. Our assumptions suggest a typical global portfolio, consisting of 50% large-cap equities, 30% bonds, and 20% alternatives, will produce an annual nominal return of only 3.0%, compared to an average of 6.3% over the past 20 years. A US-only portfolio with a similar composition is likely to produce only a 3.1% return, compared to 7% in history. The reason is simple: Valuations currently are very stretched in almost every asset class. The risk-free rate (the 10-year government bond yield) in the US is 1.6% (compared to a 20-year average of 3.1%). It is negative in the euro area (in nominal terms) and zero in Japan. These rates are the anchor for the returns of all other asset classes, which are theoretically priced off the risk-free rate plus a risk premium. We have long argued that valuations are not a good timing tool for investors. An asset can remain very expensive or very cheap for a considerable period. But all the evidence shows that the valuation at the starting point is a very powerful indicator of long-run returns. The yield on government bonds, for example, has a strong correlation with their 10-year return (Chart 1). In the equity market, the Shiller PE has historically had little correlation with the return over one or two years, but has a 90% correlation with the return over the subsequent 10 years (Chart 2). Chart 1Starting Yield Determines Bond Returns Chart 2Valuation Drive Long-Run Equtiy Returns     With valuations in equity markets now expensive relative to history (for example, forward PE for US stocks of 22x compared to a 20-year average of 16x, and 18x in the euro zone compared to 13x), investors should expect that equity market returns will be low relative to history. Our assumptions point to a 2.6% annual return from US stocks, 2.3% from the euro zone, and 1.6% from Japan (compared to 8.5%, 3.9%, and 3.5% over the past 20 years). Our assumptions are significantly lower than when we last published our analysis in 2019; then we projected 5.6% for US stocks, 4.7% for the euro zone, and 6.2% for Japan. The difference is that equity multiples have risen and risk-free rates have fallen significantly since then. So what should investors do? They have only two choices: Lower their return assumptions, or increase their weightings in riskier asset classes. Chart 3Hard To See How US Pension Funds Will Achieve Their Targets The average US public pension fund (Chart 3) still assumes a return of 7% a year, and private pension funds’ assumption is not much lower. And yet corporate pension funds have been pushed by their consultants in recent years to increase their weighting in bonds, to more closely match their liabilities (Chart 4). It is almost mathematically impossible to achieve their targets with that sort of portfolio. In other countries, such as Australia or Canada, pension funds’ return targets are typically inflation or cash plus 3-4 percentage points. But even those targets are challenging.   Chart 4...Especially With Over 50% In Bonds There are asset classes which will produce higher returns. For example, we project a return of 4.9% from US small-cap stocks – and 9.7% from UK small caps. US high-yield bonds should produce a return of 3.2% a year (even after defaults) and Emerging Markets local currency sovereign debt 2.7% (in USD terms) – not exactly exciting, but at least a pick-up over other fixed-income securities. The projected returns from illiquid alternative assets continue to look relatively attractive. An equal-weighted portfolio of the 12 alternatives we cover is projected to return 5.7% a year, not much lower than the forecast of 6.1% from our 2019 report (and compared to an average of 7.1% of the past 20 years). There are some alt assets where returns have started to trend down: Private equity, for instance, is projected to return 6.2% a year, compared to 11.1% in history, and hedge funds 4.5%, compared to 5.9%. But the illiquidity premium should not disappear completely, even if the move of alternative investments to become more mainstream has reduced it to a degree. So adding more risky assets to a portfolio is an answer, at least for those investors with a long enough time-horizon that allows them to bear the inevitable big drawdowns that come with having a more volatile portfolio. And, unfortunately, lower returns mean that the incremental return gained for each unit of risk taken has declined compared to the past 10 or 20 years (Chart 5) – the efficient frontier has flattened significantly. Chart 5You Need To Take More Risk To Produce Return How We Came Up With The Assumptions GDP Growth Several of our methodologies use assumptions (for example, in equity methods (2) and (3), based on projections of earnings growth, real-estate capital-value growth, and commodities prices) which require estimates of nominal GDP growth in each country and region. To make these forecasts, we assume that nominal GDP growth can be decomposed into: (1) growth of the working-age population, (2) productivity growth, and (3) inflation. This ignores capital intensity, but it has been relatively stable over history and is difficult to forecast. Table 2 shows the assumptions we use, and our forecasts for real and nominal GDP in each country and region. Table 2Calculations Of Trend GDP Growth For population growth we use the United Nations’ median forecast of annual growth in the population aged 25-54 between 2020 and 2040. This ranges from -1% in Japan to +1% in Emerging Markets – although note that the range of forecast population growth in EM varies widely from 1.2% in India to -1.1% in Korea (and in China, too, is negative at -0.7%). This estimate is reasonably reliable, although it does miss some possible factors, such as changes in the female participation rate, hours worked, and changing openness to immigration. Productivity is much harder to forecast. Over the past 10 to 20 years, productivity growth has trended down in most countries (Charts 6A & B). We take a slightly more optimistic view, assuming that productivity growth over the next 10-15 years will equal the 20-year average. We base this on the belief that part of the decline in productivity since the Global Financial Crisis is due to cyclical reasons which are now dissipating, and also to expectations that new technologies coming through (artificial intelligence, big data, automation, robotics etc) will boost productivity in the coming years. Others take a more pessimistic view. The Congressional Budget Office’s forecast of trend real US GDP growth in 2022-2031 of 1.8%, for example, is lower than our estimate of 2.2% mainly because of its more cautious estimate of productivity growth. Chart 6AProductivity Growth (I) Chart 6BProductivity Growth (II)   To derive nominal GDP growth, we assume that inflation over the next 10 years will be on average the same as over the past 20 years, for example 2% in the US, 1.6% in the euro area, 0.1% in Japan, and 3.9% in Emerging Markets (using a weighted average of EM by equity market cap). This estimate, too, has a high degree of uncertainty. One could imagine a scenario whereby inflation picks up significantly over the next decade due to excessively easy monetary policy, overly generous fiscal spending, growth in protectionism, rising labor pressure for wage increases, and the effects of a rising dependency ratio (the ratio of non-working people, especially retirees, to total population).1 But another scenario of continued “secular stagnation” and disinflation, caused by automation-driven job losses and a chronic lack of aggregate demand, is also conceivable. We think our middle-path forecast is the most sensible one to use in projecting likely asset returns, but investors might also want to plan based on these alternative scenarios too. Note that for Emerging Markets, we continue to show two different scenarios, which vary according to different projections of productivity growth. EM productivity growth has been declining steadily since around 2010, and in all major emerging economies, not just China. Our first scenario assumes that this decline ends and that, as in our assumption for developed economies, productivity growth reverts to the 20-year average. The more pessimistic (and, in our view, more likely) scenario assumes that the deterioration in productivity continues and that in 10 years’ time, EM productivity is the same as the average of developed economies. Which scenario will be correct depends on whether emerging economies, not least China, are able to implement structural reforms over the next decade, for example liberalizing the labor market, allowing a greater role for the private sector, improving corporate governance, and institutionalizing more orthodox fiscal and particularly monetary policy. Fixed Income Our anchor for calculating assumed returns is the return on long-term risk-free assets, specifically the 10-year government bond in the strongest countries. It is a reasonable assumption that an investor who buys, for example, a 10-year Treasury bond today and holds it for 10 years will make 1.6% a year in nominal US dollar terms. While this is not perfectly mathematically correct (since it ignores reinvested interest payments, for instance), empirically the return on government bonds has been very closely linked to the yield at the start-point in history (see Chart 1). From this starting-point in each country, we can easily build up the return for other fixed-income assets. These assumptions and the results are shown in Table 3. Table 3Fixed-Income Return Calculations Government bonds in most countries have an average duration of less than 10 years. Over the past five years, in the US it has averaged 6.4 years, and in the euro area 8.0 years. Only in the UK is the average over 10 years: 12.4 years to be precise. To calculate the return from the government bond index for each country we therefore assume that the shape of the yield curve (using the spread between 7-year and 10-year bonds) in future will be the same as the historic 20-year average. Cash. We assume that over the next 10 years the yield on cash will gradually revert to an equilibrium level. We calculate a market-implied real long-term neutral rate from the 10-year historical average of 5-year/5-year OIS implied forwards deflated by the 5-year/5-year implied CPI swap rate. This is a change from the methodology we used in 2019, when we based this off the neutral rate, r*, as calculated by the Holston Laubach-Williams model. But the New York Fed has temporarily stopped updating its calculation of this due to pandemic-induced volatility in the data, and anyway it was not available for every country. We turn the real cash rate into a total nominal return using our assumption for inflation described in detail in the GDP section above, the 20-year historical average of CPI. For inflation-linked securities, such as TIPS, we take the average yield over the past 10 years (a 20-year average was not available in many markets) and add the assumption for inflation described above. Corporate credit. We assume that spreads, and default and recovery rates, while highly volatile over the cycle, remain stable in the long run (Chart 7). We use 20-year averages for these, except that data for investment-grade default rates in Japan, the UK, Canada, and Australia are not available and so we use the average of the US and the euro zone. High-yield default rates are not available for the UK either, and so we do the same. Other bonds. For government-related debt (which is a big part of some bond indexes, 28% in the US for example) we assume that the 20-year historical average of the option-adjusted spread over government bonds will apply in the future too. We use the same methodology for securitized debt (for example, mortgage- and asset-based bonds): The 20-year average spread over the return on government bonds. Emerging Market debt. The assumptions and results for the three categories of EM debt (US dollar sovereign debt, US dollar corporate debt, and local currency sovereign debt) are shown in Table 4. We here assume that the 20-year average historical spread will continue in future. Default and recovery rates are a little harder to calculate, due to a lack of data. For USD sovereign debt (where defaults are rare and so hard to project), we use the rating-based default rate, calculated by Aswath Damodaran of NYU Stern School of Business.2 For USD-denominated EM corporate debt, we use the historical average, calculated by Moody's 2.5%.3 For local-currency debt, we use the same rating-based default rate as for USD sovereign debt. To translate the return into hard currency, we assume that currencies will move in line with the inflation differential between Emerging Markets and the US. For EM inflation we use an average of the IMF’s inflation forecasts for the nine largest emerging markets weighted by their weights in the J.P. Morgan GBI-EM Global Diversified local government bond index, and compare this to our US inflation forecast. This produces an EM inflation forecast of 2.9% a year, compared to 2.2% for the US, thus lowering the USD-based return from local EM debt by 0.7 percentage point. (See a more detailed discussion of forecasting long-term EM currency changes in the Currency section below). Index returns. Table 3 also shows the assumed return for the Bloomberg Barclays bond index for each country and for the global bond index, based on a weighted average of our assumption for each fixed-income asset class and country. Chart 7ACredit Spreads & Default Rates (I) Chart 7BCredit Spreads & Default Rates (II)   Table 4Emerging Market Debt   Equities The assumptions and detailed results for seven different equity markets are shown in Table 5. We have not made any substantial changes to our methodology for equities. We continue to use the average of six different methods to calculate the probable equity returns over the next 10-15 years. These are: Equity Risk Premium (ERP). The return from equities equals the yield on government bonds (we use 10-year bonds) plus an equity risk premium. For the US, we use an equity risk premium of 3.5%. This is based on work by Dimson, Marsh and Staunton4 showing that this is approximately the average excess return of equities over bonds in developed economies since 1900. We scale the equity risk premium for other countries using their average beta to the US market over the past 10 years. This varies from 0.66 for Japan (giving an ERP of 2.3%) and 1.2 in the euro area (ERP is 4.2%). Growth model. Here we assume that the return from equities equals the current dividend yield plus dividend growth. We need to adjust the dividend yield, however, to take into account that in some countries, particularly the US, it is more tax efficient for companies to do buybacks than to pay out dividends. We do this by adding equity withdrawals to the dividend yield. But this needs to be done on a net basis (taking into account equity issuance). We calculate this using the average annual change in the index divisor over the past 10 years. For the US, this is -0.8%, meaning there are more buybacks than new share issues. But in all other regions, the number is positive, and as high as 5.9% a year for Emerging Markets. This dilution is something that many calculations of assumed equity returns miss. For dividend growth, we assume that the dividend payout ratio remains stable, and that earnings growth is correlated with nominal GDP growth. However, history shows that earnings grow more slowly than GDP (logically so, when you consider that companies usually grow fastest before they list on a stock exchange). So we deduct 1% from nominal GDP growth to derive our earnings growth assumption. Note that for Emerging Markets, we use two different measures of dividend growth, depending on future productivity growth, as detailed above in our explanation of the GDP projections. Growth model (with reversion to mean). To take into account that valuations and profit margins typically revert to mean over the long run, we adjust the standard growth model (No. 2 above) by assuming that the current 12-month forward PE ratio and forward net profit margin for each country gradually revert over the next 10 years to their 20-year average. In the US, for example, that would mean that the current 12-month forward PE of 22.5x falls back to 16.0x, and profit margin of 12.5% falls to 10.7%. In every country and region, the profit margin is currently above the long-run average, and in all except the UK the PE is too. Note that we have changed from using the trailing PE and margin, because to use these now would be misleading given the big pandemic-driven decline in profits in 2020. Earnings yield. An intrinsically intuitive (and empirically demonstrable) way of estimating future returns is to use the earnings yield. This is based on the idea that an investor’s return from owning a stock comes either from the company paying a dividend, or from it investing retained earnings and paying a dividend in future. In the US, for example, a forward PE of 22.5x translates into an earnings yield of 4.4%. Again, here we switched this time to using 12-month forward forecast earnings yield, rather the trailing. Shiller PE. There is a strong correlation between valuation at the starting-point and the subsequent return from equities, at least over the long-run, although not over a period of less than 3-5 years (Chart 2). We regressed the Shiller PE (current price divided by average real earnings over the past 10 years) against the return from equities over the subsequent 10 years for each country and region. Composite valuation metric. The Shiller PE has its detractors. Using a fixed 10-year period does not reflect the different lengths of recessions and bull markets. It may say more about the mean-reverting nature of earnings than about whether the current price level is too high. So we also use the BCA Compositive Valuation Metric, which comprises eight indicators including, besides standard valuation measures such as price/sales and price/book, more esoteric ones such as market cap/GDP and Tobin’s Q. Again, we regress the metric against the subsequent 10-year return. Table 5Equity Return Calculations Alternative Assets Real Estate & REITs. We use the same basic methodology for both: The current yield (cap rate or dividend yield) plus projected capital value appreciation (linked to GDP growth). For US direct real estate, for example, we use the simple average cap rate of the five categories of commercial real estate (CRE), apartments, office, retail, industrial, and hotels in major cities: 6.1%. We also use the simple average of available city and category data for other countries. Cap rates are notoriously hard to estimate precisely; our data include a range of real estate, not just prime locations. We assume that capital values will grow in line with nominal GDP growth (using the same assumptions for this as we used for equities, 4.2%). We then deduct 0.5% for maintenance. This produces an expected return of 9.8% for the US. The only difference for REITs is that we do not deduct maintenance since this should already be reflected in the dividend yield. US REITs have a dividend yield currently of 3.5%, which produces an assumed return of 7.7% (Table 6). One risk with this methodology is that in the post-pandemic world, work and life practices might change. This will hurt office and residential real estate in major cities (which are overrepresented in investible CRE), though smaller cities and rural areas might benefit. As a result, capital values might fall. Table 6Alternatives Return Calculations Farmland & Timberland. Our methodology is similar to that for real estate: Current yield plus projected growth in capital values. For farmland, we use the farmland renter yield, sourced from the US Department of Agriculture. To estimate future land values, we take the gap between land value growth over the past 40 years (3.7%) and nominal growth of world GDP over that time (5.2%), assume that gap will continue and so deduct it from our estimate of global nominal GDP growth going forward (3.6%). This gives a result of 6.5%. For timberland, we assume that annualized returns in the future are the same as over the past 20 years. This produces a return assumption of 5.7%, which is (logically) moderately lower than our assumed return for farmland. Private Equity & Venture Capital. We project the return for private equity (PE) using the 30-year time-weighted average of the three-year rolling annualized return of PE over US large-cap equities, 3.6% (Chart 8). This produces an assumed return of 6.2%. For venture capital (VC), we use the same historical average for VC over PE (0.4%) to arrive at an assumed return of 6.6%. Hedge Funds. We use the 20-year time-weighted return of the Hedge Fund Composite Index over cash, 3.5% (Chart 9). This projects a future annual nominal return of 4.5%. Commodities. We previously used a methodology based on the idea that commodities’ bear markets in history have been rather fairly consistent, lasting on average 17 years, with an average decline of 50%, and that the current bear market began in 2012 (Chart 10). However, there are arguments that a new “commodities super-cycle” may be starting, driven by government infrastructure spending, and investment in alternative energy.5 We are agnostic for now on whether that will be the case, but it makes sense to switch to a neutral methodology, more in line with what we use for other assets classes: The return from commodities relative to GDP over the long run. Specifically, the CRB Raw Industrials Index has risen by an annualized 1.6% since 1951, during which time US nominal GDP growth averaged 6% (Chart 11). We assume that the differential will continue in future (although we calculate growth using global, not US, GDP), giving an annual return from commodities over the next 10-15 years of -0.9%. Gold. We calculate this using a regression of the gold price against nominal GDP growth and the annual change in the real 10-year yield over the past 40 years. For the forward-looking return assumption, we use a forecast of real rates (based on the equilibrium cash rate plus the average historical spread between the 10-year yield and cash) and a forecast of global nominal GDP growth. This produces an assumed return of 3.8%. Structured products. This asset class consists mainly of mortgage-backed and other asset-backed securitized instruments. In the US, these have historically returned 0.6% over US Treasurys. We assume that this premium continues, producing a total future return of 1.1% a year. Chart 8Private Equity Premium Chart 9Hedge Fund Return Over Cash     Chart 10Commodity Prices In History Chart 11Commodity Prices Vs. GDP Growth     Currencies Chart 12Currencies Tend To Revert To PPP To translate our local currency returns into an investor’s base currency, we need to arrive at some projections for FX movements over the next decade. Fortunately, for developed market currencies at least, it is relatively straightforward to use purchasing power parities (PPP) to do this since, over the long run, all the major currencies have tended to revert to PPP (Chart 12). We assume that in 10 years’ time all currencies will trade at PPP. We use the IMF’s estimate of today’s PPP for each currency to calculate the current under- or over-valuation. We assume that PPP will change in future years according to the relative inflation between each country and the US. The IMF provides five-year inflation forecasts and we assume that inflation will continue at this rate until 2031. For the euro zone, we calculate the PPP of the euro using the GDP-weighted PPPs of the five largest economies. The results (Table 7) suggest that the US dollar is currently overvalued and, given the forecast of higher inflation in the US than elsewhere in the future, will depreciate significantly against all major currencies except the Australian dollar. The USD is projected to depreciate by 1.7% a year against the euro and 1.1% against the yen over the next 10 years. It is likely to appreciate by 1.3% a year against the AUD, however. Table 7Currency Return Calculations Emerging Markets (Table 8) are more complicated. There is no evidence that EM currencies move towards PPP over time. All the major EM currencies are currently very cheap versus PPP (varying from 34% undervalued for the Chinese yuan to 67% for the Indonesian rupiah) but they were 10 years ago, too, and have not significantly moved towards PPP over that time. Table 8EM Currencies To calculate likely EM currency moves against the USD, therefore, we carry out a regression of the nine largest EM currencies against their relative CPI inflation rate to US inflation in history. We assume an intercept of zero. The regression coefficients vary from +0.5 for China to -1.7 for Malaysia. Apart from China, Malaysia, Poland and South Africa, the coefficients were negative, meaning that historically the USD has strengthened against the EM currency at least partly in line with relative inflation. To calculate likely future currency movements, we use the IMF’s five-year inflation forecasts and assume that the same rate of inflation will continue for our whole projection period. This methodology points to moderate annual depreciation of most EM currencies against the USD, varying from 0.8% a year for the Russian ruble to 0.1% for the Indonesia rupiah. The Chinese yuan and Taiwanese dollar are projected to appreciate moderately. We calculate the average EM currency movement using the weights of these nine large economies in the EM J.P. Morgan GBI-EM Global Diversified local-currency sovereign bond index. This produces a small (0.1%) a year appreciation. However, the IMF’s EM inflation forecasts may be too optimistic. It forecasts, for example, that Brazilian inflation will be only 3.3% a year in future, compared to an average of 6.1% over the past 20 years, and Russian inflation 4.0% versus a historical average of 9.3%. This suggests that EM currency performance could be worse than our projections. Table 9 shows the returns for the major asset classes expressed in local currency terms for six base currencies, based on the calculations explained above. Table 9Returns In Different Base Currencies Correlation And Volatility Below, in Table 10, we provide correlations for clients who need these inputs for their optimization calculations. Table 10Long-Run Correlation Matrix Returns can be calculated using the sort of forward-looking methodologies we have described above. For volatility, we think it is reasonable to use historical average data (Table 1, far right column), since volatility does not tend to trend over the long run (Chart 13). But correlation is a different matter. Correlations have varied significantly in history due to structural changes or regime shifts. The correlation of equities to bonds, it is well known, has moved from positive in the 1980s and 1990s, to negative since 2000 – probably because inflation disappeared as a factor moving bond prices (Chart 14). The correlation between equity market has risen as a result of the globalization of investment flows, though note that it fell back in 2010-2019. Chart 13Volatility Is Fairly Stable In The Long Run Chart 14Correlations Are Not Stable   So what correlations should investors use in an optimizer? Our recommendation would be to use the longest period of history available. A US investor, for example, might take the average correlation between Treasury bonds and large-cap US equities since 1945, 0.1%. Table 10 shows the correlation since 1973 of all the major asset classes for which data is available. Unfortunately, this misses some important asset classes such as high-yield bonds and Emerging Market equities, whose history does not go back that far. The results are intuitive – and prudent. From these numbers, it would seem sensible to use an assumption of a small positive correlation between US Treasurys and US equities, for example. US investment-grade debt has a correlation of 0.4 against equities. Global equity markets are all fairly highly correlated to each other, ranging mostly from 0.4 to 0.7. The most non-correlated asset class is commodities, especially gold.   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com   Footnotes 1 These are themes that BCA Research has been writing about for several years. See, for example, please see Global Investment Strategy, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; and " 1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. 2 Please see http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html 3 Annual Emerging Markets Default Study: Coronavirus Will Push Up Default Rates https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1214906 4 Please see, for example, https://www.credit-suisse.com/media/assets/corporate/docs/about-us/research/publications/credit-suisse-global-investment-returns-yearbook-2021-summary-edition.pdf. 5 Please see Commodity & Energy Strategy, "Industrial Commodities Super-Cycle Or Bull Market?", dated March 4, 2021.

Dear client, In addition to this weekly report, we also sent you a Special Report on cryptocurrencies, authored by my colleagues Guy Russell and Matt Gertken. The conclusion is that government authorities are likely to lean against the proliferation of cryptocurrencies, something we suspected in our most recent report on the topic. Regards, Chester Highlights Net foreign inflows into US assets probably peaked in March. Meanwhile, there are strong reasons to believe outflows from US securities will accelerate in the coming months. As such, the 12-18-month outlook for the US dollar remains negative. Cryptocurrencies are correcting sharply amidst a crackdown in China, a risk we warned investors about in our Special Report last month. We are increasingly favoring the yen. Lower the limit-sell on USD/JPY to 109. Hold long CHF/NZD positions recommended last week. Feature Chart I-1Current Account Deficit = Capital Account Surplus The US runs a sizeable trade deficit. As such, it must import capital to finance this deficit (Chart I-1). Over the last year, this has been driven by equity and agency bond purchases by foreigners. However, we might be at the apex of a shift, where foreign appetite for US securities starts a meaningful decline. Financing The US Deficit TIC data is usually a lagging indicator for FX markets, but still holds valuable insights into foreign appetite for US assets. On this front, the March data was particularly instructive: There were strong inflows into US Treasury notes and bonds, to the tune of almost $120 bn. This was the greatest driver of monthly inflows. This was also the largest monthly increase since the global financial crisis. Net inflows into US equities stood at $32.2 bn in March. This is on par with the three-month average, but a sharp deceleration from December inflows of $78.3 bn. Corporate bonds commanded particularly strong inflows in March to the tune of $43.1 bn. It appears that foreign private concerns swapped their agency bond purchases with corporate bonds. US residents repatriated $54.1 bn back home in March. Official concerns were big buyers of long-term US Treasury bonds, but this was offset by a large sale of US T-bills. Net foreign official purchases of overall US securities were just $6.5 bn. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. The question going forward is whether there has been a regime shift in US purchases, specifically the purchase of equities (and agency bonds). And if so, can the purchase of US Treasurys pick up the slack (Chart I-2). Foreign inflows into the US equity market tend to be driven by expected rates of return, either from an expected rerating of the multiple or from profit growth. A rerating of the US equity multiple, relative to the rest of the world, has inversely tracked interest rates (Chart I-3). This is due to the higher weighting of defensive sectors in the US equity market. Concurrently, we showed in a recent report that profit growth on an aggregate level also tends to move in sync with relative economic momentum.1  Chart I-2Equity Inflows Have Financed ##br##The US Deficit Chart I-3Rising Bond Yields Would Curtail Equity Inflows If growth is rotating away from the US, and global bond yields still have upside, this will curtail foreign appetite for US equities. This appears to be the story since March, as non-US bourses have outperformed (Chart I-4). Chart I-4ANon-US Markets Are Bottoming Chart I-4BNon-US Markets Are Bottoming In terms of fixed income flows, the rise in US bond yields towards a peak of circa 180bps in March undoubtedly triggered strong inflows into the US Treasury market. Since then, yields outside the US have been moving somewhat higher, especially in Germany. This should curtail bond inflows, and also fits with a growth rotation away from the US. While foreign central banks were net buyers of US Treasurys in March, the “other reportables” category from the CFTC data show a huge short position in US 10-year futures. Foreign central banks are usually grouped in this category. This will suggest the accumulation of Treasurys should reverse in the coming months (Chart I-5). Chart I-5Did Central Banks Hedge Their March Purchases? A rotation of growth from the US towards other parts of the world would also make it more difficult to finance the US current account deficit. This is because it will compress real interest rate spreads between the US and the rest of the world. From a historical perspective, inflows into US Treasury assets only tend to accelerate when real rates in the US are at least 50-100 bps above that in other G10 economies (Chart I-6). That could explain why despite a positive Treasury-JGB spread of 165 basis points, Japanese investors were very much absent buyers in March (Chart I-7). Chart I-6Real Rate Differentials And Bond Capital Flows Chart I-7The Big Boys Did Not Buy Much Treasurys In March Critical to this view is the outlook for US inflation. On this front, we note the following: First, the output gap in the US should close faster than most other economies, at least according to the OECD (Chart I-8). Ceteris paribus, US inflation should outpace that in other countries in the near term and put downward pressure on real rates. Chart I-8The US Should Generate Higher Inflation Fiscal spending has been more pronounced in the US compared to other countries, which will further fan the inflationary flames. The Fed is the only central bank in the G10 committed to an inflation overshoot. In a nutshell, there is compelling evidence to suggest US inflows peaked in March from both foreign equity and bond investors. Upside surprises in inflation are more likely in the US in the very near term compared to other economies, which will depress real rates. Meanwhile, higher global yields are also a negative for the US equity market. There Is No Alternative Chart I-9A Deep And Liquid Pool Of Treasurys My colleague, Mathieu Savary, has made the case that there is no alternative to US Treasurys. The treasury market is the most liquid and the deepest safe haven pool in the capital market universe (Chart I-9). Ergo, a flight to safety will always bid up Treasurys, as we saw in March 2020. We do agree that Treasurys will continue to act as the world’s safe haven benchmark for now. However, that privilege is fraying at the edges, and it is the marginal changes that matter for dollar investors. Competition for safe haven assets continues to intensify as the narrative switches from 40 years of disinflationary forces to the rising prospect of an inflation overshoot. Inflation is anathema to fiat currencies, including the dollar. For investors, precious metals have been a preferred habitat for anti-fiat holdings. That said, cryptocurrencies are also rising in the ranks as an alternative. In our Special Report2 released a month ago, we suggested government regulation was a huge risk for cryptocurrencies. But more specifically, the degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Since the peak in the DXY index in 2020, the biggest sellers of US Treasurys have been private investors. Cryptocurrencies benefited from this diversification. That has changed since March, which partly explains the big drawdown in crypto prices. In general, you always want to align yourself with strong buyers who are price indiscriminate. Foreign central banks (the biggest holders of US Treasurys) prefer gold as their anti-dollar asset. This puts an solid footing under gold prices, compared to cryptocurrencies or other anti-fiat assets. It is worth noting that competition between the dollar and gold often run in long cycles. In the 1970s, as inflation took hold in the US, the dollar depreciated and gold soared. In the 1980s, the dollar took off and gold fell sharply, as the Federal Reserve was able to bring down inflation. The 1990s were relatively disinflationary, which supported the dollar (Chart I-10). A whiff of rising inflation in the early 2000s hurt the dollar, while the 2010s were characterized by very low inflation, supporting the dollar. More recently, the dollar is weakening as inflationary trends accelerate faster in the US (Chart I-11). Chart I-10The Dollar And Inflation Move Opposite Ways (1) Chart I-11The Dollar And Inflation Move Opposite Ways (2) One of our favorite indicators for gauging ultimate downside in the dollar is the bond-to-gold ratio. The rationale is that the bond-to-gold ratio should capture investor preference at the margin for either US Treasurys or gold. This in turn has been a good measure of investor confidence in the greenback. On this basis, the bond-to-gold ratio (TLT-to-GLD ETF) is breaking down to fresh cycle lows (Chart I-12). This has historically pointed towards a lower US dollar. Chart I-12The Dollar And The Bond-To-Gold Ratio Within precious metals, we like gold but love silver. As such, we are short the gold-to-silver ratio since an entry point of 68. Our bias is that initial support for this ratio is 60. Meanwhile, we also like platinum, and will go long versus palladium at current levels. A Few Other Indicators A few other market developments are pointing to a lower dollar in the coming months. The dollar tends to decline in the second half of the year. This has been true since the 1970s (Chart I-13). Importantly, even during the Paul Volcker years in the 80s when the dollar staged a meaningful rally, it often fell in the second half of the year. The winner in the second half of the year has usually been the Swiss franc and the Japanese yen (Chart I-14).  Chart I-13The Dollar Usually Strengthens In H1 Chart I-14The Dollar Usually Weakens In H2 The OECD leading economic indicators still suggest US growth remains robust relative to the rest of the G10. However, our expectation is that this gap will decrease sharply in the second half of this year. That said, the current reading is a risk to our dollar bearish view (Chart I-15). Chart I-15US Exceptionalism Is A Risk For Dollar Bears Lumber has started to underperform Dr. Copper. Lumber benefits from solid US housing activity, while copper is more tied to global growth and the emerging investment in green technology. As a counter-cyclical currency, the dollar also tends to underperform higher beta currencies when lumber is underperforming copper (Chart I-16). The copper-to-gold ratio has also bottomed, suggesting ample liquidity is now fueling growth (Chart I-17). We suggested last week that the velocity of money across countries was a key variable to watch in getting the dollar call right. So far, the collapse in money velocity is least acute in China, explaining the rise in the copper-to-gold ratio and the improvement in non-US yields compared to the US. Chart I-16Lumber/Copper Prices And The Dollar Chart I-17Copper/Gold Prices And Bond Yields In summary, many cyclical indicators still point to a lower dollar. The key risk to this view is an equity market correction, and/or persistent relative strength in US growth.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Report, "Trading Currencies Using Equity Signals," dated May 7, 2021. 2 Please see Foreign Exchange Special Report, "Will Cryptocurrencies Displace Fiat," dated April 23, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand.  This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption.  We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year.  This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023.  Chart 3US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Chart 7Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond.   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 The Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 Chart 11     Footnotes 1     Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … Chart 6B… As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus Chart 9Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com

Highlights Over the 2021-22 period, renewable capacity will account for 90% of global electricity-generation additions, per the IEA's latest forecast. This will follow the 45% surge (y/y) in renewable generation capacity added last year, which occurred despite the COVID-19 pandemic (Chart of the Week). Continued investment in renewables and EVs – along with a global economic rebound – are pushing forecasts at banks and trading companies to a $13k - $20k/MT range for copper, vs. ~ $10.6k/Mt (~ $4.80/lb) at present. Should these stronger metals forecasts prove out, investments that extend low-carbon use of fossil fuels via carbon-capture and circular-use technologies will become more attractive. Investment in these technologies has been limited because there is no explicit global reference price to assess investments against. A carbon market or tax would provide such a bogey and accelerate investment. It could be monitored via a Carbon Market Club, which would limit trade to states posting and collecting the tax.1 Feature At almost 280GW, renewable energy capacity additions last year increased 45% y/y, the most since 1999, according to the IEA's most recent update on renewable energy.2 For this year and next, renewables are expected to account for 90% of capacity additions, led by solar PV investment increasing ~ 50% to 162GW. Wind capacity grew 90% last year, increasing to 114GW, and is expected to increase ~ 50% to end-2022. As renewables generation – and EV investment – continues to grow, demand for bulks (steel and iron ore) and base metals, led by copper, will pull prices higher. This is occurring against a backdrop of flat supply growth and physical deficits over the four years ended 2020 (Chart 2). According to the IEA, a 40% increase in steel and copper prices over the September 2020 to March 2021 period played a role in higher solar PV module prices. Chart of the WeekRenewables Capacity Surges The supply side of the copper market will remain in deficit this year and next, in our assessment, and may continue on that trajectory if, as Wood Mackenzie expects, demand grows at a 2% p.a. rate over the next 20 years and miners remain reluctant to commit to the capex required to keep up with demand.3 Chart 2Physical Deficits Will Draw Copper Stocks... ESG risk for copper – and other metals required to build the generation and infrastructure required in the renewables buildout – will increase as prices rise, which also will add to cost.4 Cost increases coupled with increasing ESG risks in this buildout will increase the attractiveness of carbon-capture and circular-economy technology investment, in our view. This would extend the use of low-carbon fossil fuels if the technology can move the world closer to a net-zero carbon future. However, unless and until policy catalyzes this investment, – e.g., via a global carbon trading price or tax – investment in these technologies likely will continue to languish. Carbon-Capture Tech's Unfulfilled Promise The history of Carbon Capture, Utilization and Storage (CCUS) has been one of high hopes and unmet expectations. It is generally recognized as a route to mitigate climate change; however, its deployment has been slower than expected. Low-carbon technology requires more critical metals than its fossil-fuel counterpart (Chart 3). Apart from the issue of cost, the ESG risks of mining metals for the renewable energy transition will increase as more metals are demanded, which we discussed in previous research.5 According to Wood Mackenzie, mining companies will need to invest nearly $1.7 trillion in the next 15 years to help supply enough metals to transition to a low carbon world.6 Chart 3Low-Carbon Tech Is Metals Intensive Given these looming physical requirements for metals, fossil fuels most likely will need to be used for longer than markets currently anticipate, as a bridge to the low-carbon future, or as part of that future, depending on how successfully carbon is removed from the hydrocarbons used to power modern society. If so, using fossil fuels while mitigating their environmental impact will require highly focused technology to lower CO2 and other green-house gas (GHG) emissions during the transition to a low-carbon future. Enter CCUS technology: This technology traps CO2 from sources that use fossil fuels or biomass to make the energy required to run modern societies. In the current iterations of this technology, CO2 can either be compressed and transported, or stored in geological or oceanic reservoirs. This can then be used for Enhanced Oil Recovery (EOR) to extract harder-to-reach oil by injecting CO2 into the reservoirs holding the hydrocarbons.7 The Scope For CCUS Investment CCUS investment spending is increasing, as are the number of planned facilities using or demonstrating this technology. In the 2020 edition of its Energy Technology Perspectives, the IEA noted 30 new integrated CCUS facilities have been announced since 2017, mostly in advanced economies such as US and Europe, but also in some EM nations. As of 2020, projects at advanced stages of planning represented a total of $27  billion, more than double the investment planned in 2017 (Chart 4). Among its many goals, the Paris Agreement seeks a balance between emissions by man-made sources and removal by greenhouse gas (GHGs) sinks (absorption of the gases) in the second half of the 21st century. Practically, many countries – especially EM economies – will still need to use fossil fuels to develop during this period (Chart 5).8 Chart 4Carbon-Capture Projects To Date Chart 5EM Development Will Require Fossil-Fuel Energy CCUS In The Energy Sector As a fuel that emits fewer GHGs than coal – i.e., half the CO2 of coal – natural gas can be used effectively as a bridge to green-power generation (Chart 6). Chart 6Natural Gas Will Remain Attractive As A Bridge Fuel The CO2 in natgas needs to be removed before dry gas is sold as pipeline-quality gas or LNG. This CO2 is normally vented to the atmosphere; however, by using CCUS technology, it can be reinjected into geological formations and used for EOR. For this reason, LNG companies in the US, the world’s largest LNG exporter, have been looking into investing in CCUS technology in a bid to become greener.9 CCUS can also be used to produce low-cost hydrogen – so-called blue hydrogen – using natural gas and coal, as opposed to the more expensive electrolysis process, which uses renewables-based electricity to produce "green" hydrogen. The lower blue-hydrogen costs will make clean hydrogen more accessible to emerging nations, opening new avenues for the world to use the energy carrier in its decarbonization effort. The Value Of Ccus In Other Industries CCUS technology can be retrofitted to existing power and industrial plants, which, according to the IEA, could otherwise still emit 8 billion tons of CO2 in 2050, around one-quarter of annual energy-sector emissions in 2020. Of the fossil fuel generators, coal-fired power generation presents the biggest CO2 challenge, with most of the emissions coming from China and other EM Asia nations, where the average plant age is less than 20 years. Since the average age of a coal fired power plant is 40 years, according to the US National Association of Regulatory Commissioners, this implies that these plants have a long remaining life and could still be operating until 2050. CCUS is the only alternative to retiring or repurposing existing power and industrial plants. The IEA believes that CCUS is imperative to reach net-zero carbon emissions. In its Sustainable Development Scenario - in which global CO2 emissions from the energy sector decline to net-zero by 2070 – CCUS accounts for 15% of the cumulative reduction in emissions. If the world needs to reach net-zero by 2050 instead, it will need almost 50% more CCUS deployment.10 Properly implemented and scaled, CCUS can allow industries to continue using oil, gas and coal and to attain net-zero carbon emission targets, boosting demand for fossil fuels in the medium term. This is especially important to EM development. Why Aren’t We Further Along In CCUS? What Can Be Done? The main reason CCUS isn’t used more widely is because of its cost. Currently, the cost of capturing carbon varies, based on the amount of CO2 concentration, with Direct Air Capture being most expensive (Chart 7). Given the prohibitive costs, CCUS has not been commercially viable. However, the same argument could have been used against implementing renewable sources of energy. While at one point the Levelized Cost of Energy from renewable sources was high, as these sources have been scaled up – aided in no small part by government subsidies – costs have fallen, following something akin to a Moore’s Law cost-decay curve. A Levelized Cost of Energy for solar generation reported by Lazard Ltd., which allows for comparisons across technologies (e.g., fossil-fuel vs renewable), shows generation costs fell by 89% to $40/MWh from $359/MWh from 2009-2019 (Chart 8). This learning curve was able to take place because of government subsidies, which promoted the deployment of solar technology. Chart 7CCUS Can Be Expensive Chart 8Subsides Could Support CCUS, Just As Was Done For Solar The cost of CCUS technology is falling. For example, in 2019 the Global CCS Institute reported it cost $100/ton to capture carbon from the Canada-based Boundary Dam using a CCS unit built in 2014. The cost of carbon captured at the US-based Petra Nova plant – built three years later – using improved technology was $65/ton. Both are coal-powered electricity plants. The report also noted coal-fired power plants planning to commence operations in 2024-28 using the same CCS technology as those at Boundary Dam and Petra Nova expect carbon costs to be ~ $43/ton, due to steeper learning curves, research, lower capital costs due to economies of scale, and digitalization. One commonality amongst these sources of cost reductions is that companies need to invest more into CCUS and familiarize themselves with this technology. As was the case with renewables, government subsidies would reduce the prohibitive costs of operating CCUS technology, and draw more participation to refining this technology. Early, first-of-its-kind CCUS will be expensive, however subsidies in the form of capital support or tax credits will increase CCUS implementation and research. Boundary Dam and Petra Nova are examples of facilities that benefitted from government subsidies. The facilities received $170 million and $200 million respectively from Canadian and US Government agencies at the time of the CCS units’ construction. The US has also implemented a 45Q tax credit system which pays facilities $50/ton of CO2 stored and $35/ton of CO2 if it is used in applications like Enhanced Oil Recovery. According to the Global CCS Institute, in late-2019, of the eight new CCUS projects that were added in the US, four cited the presence of 45Q as the key driver. Putting Carbon Markets And Taxes To Work The EU’s Emissions Trading System (ETS) market, which was implemented in 2005, is an example of innovative policy which incentivizes companies to curb emissions, using market forces. The price of carbon measured in these markets puts a tangible value on a negative externality, which before this went unrecorded. The downside of this ETS is its reliance on the EU's environmental policy implementation, which is subject to policy changes that complicate supply-demand analysis for longer-term planning – e.g., the recent increase in its emissions target to a minimum of 55% net reduction in GHG emissions by 2030. An alternative to policy-driven trading of emissions rights is a per-ton tax on emissions, which governments would impose and collect. This would raise costs of technologies using fossil fuels – including those used in the mining industry to increase supply of critical bulks and base metals needed for the renewables transition. At the same time, such a tax would give firms supplying and using technologies that raise CO2 levels an incentive to lower CO2 output using CCUS technologies. ETS markets and governments imposing CO2 taxes could form Carbon Market Clubs – a technology developed by William Nordhaus, the 2018 Nobel Laureate in Economics – that restrict trading to states that can demonstrate their participation and support of actual carbon-reduction detailed in the Paris Agreement via trading or tax schemes.11 As the green energy transition gains traction and governments implement more net-zero emissions policies, the price of carbon will rise. As the price of carbon rises, the price tag associated with companies’ carbon emissions will increase with it. With market participants expecting the price of carbon to continue to rise after hitting record values, the incentive for companies operating in the EU to use CCUS technology will rise, as would the incentive for firms facing a carbon tax.12 Bottom Line: Given the meteoric price rise of green metals, underfunded capex, and the ESG risks associated with mining metals for the low carbon future, we expect fossil fuels to play a larger role in the transition to a low-carbon society than markets are currently expecting. For countries to be able to use fossil fuels while ensuring they achieve their climate goals, the use of CCUS technology is important. To increase CCUS uptake, governments will need to subsidize this technology until demand for it gains traction, just like in the case of renewables. Encouraging ETS and carbon-tax schemes also will be required to catalyze action.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Commodities Round-Up Energy: Bullish Brent prices were knocking against the $70/bbl door going to press, following the IEA's assessment of a robust demand recovery in 2H21 (Chart 9). The IEA took its 1H21 demand growth down 270k b/d, owing to COVID-19-induced demand destruction in India, OECD Americas and Europe, but left its 2H21 estimate intact, making overall demand growth for this year 5.4mm b/d. The EIA also expects 5.4mm b/d demand growth for this year, and growth of 3.7mm b/d next year. OPEC left its full-year 2021 demand growth estimate at 6mm b/d. OPEC 2.0 meets again on June 1 and will look to return more of its sidelined production to the market, in our estimation. We will be updating our supply-demand balances and price forecasts in next week's report. Base Metals: Bullish Spot copper prices traded on either side of $4.80/lb on the CME/COMEX market this week as we went to press. Threats of a tax increase in Chile, where a bill calling for such a measure is making its way through Congress; a potential strike by mine workers; and a shortage of sulfuric acid used in the extraction of ore brought about, according to Bloomberg, by reduced global sulfur supplies due to lower refinery runs during the pandemic all are keeping copper well bid. Our target for Dec21 COMEX copper remains $5/lb (~ $11k/ton on the LME). We remain long calendar 2022 COMEX copper vs short 2023 COMEX copper expecting physical supply deficits to continue to force storage draws, which will backwardate the metal's forward curve. Precious Metals: Bullish US CPI data on Wednesday showed that headline inflation rose by 4.2% for the month of April compared to the previous year. While this increase is the highest since 2008, this jump could also be fueled by a low base effect – Inflation levels were falling this time last year as the pandemic picked up. While rising prices increases demand for gold as an inflation hedge, if the Federal Reserve increases interest rates on the back of this data, the US dollar will rise, negatively affecting gold prices (Chart 10). However, we do not expect the Fed to abruptly change its guidance on this report, and therefore expect the central bank will treat this blip as transitory. As of yesterday’s close, COMEX gold was trading at $1,835.9/oz. Ags/Softs: Neutral Going to press, the Chicago soybean market was surging ahead of the scheduled World Agriculture Supply and Demand Estimates (WASDE) report due out later Wednesday. Front-month beans were trading ~ $16.70/bu, up 2% on the day. This month's WASDE will contain the USDA's first estimate for demand in ag markets for the 2021/22 crop year. Markets are expecting supplies to tighten as demand strengthens. Chart 9 Chart 10   Footnotes 1     Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016.  The intellectual and computational framework for such technology was developed by William Nordhaus, the 2018 Nobel Laureate in Economics. 2     Please see Renewable Energy Market Update, Outlook for 2021 and 2022.pdf, published by the IEA this week. 3    WoodMac notes, "without additional substantial investment, production will decline from 2024 onwards. Coupled with demand growth, this decline in output will lead to a theoretical shortfall of around 16 Mt by 2040."  The consultancy estimates an additional $325 - $500+ billion will be needed to meet copper demand over this period.  Please see Will a lack of supply growth come back to bite the copper industry? Published 23 March 2021 by woodmac.com. 4    Please see Renewables ESG Risks Grow With Demand, which we published 29 April 2021.  It is available at ces.bcaresearch.com. 5    Refer to footnote 4. 6    Please see Low carbon world needs $1.7 trillion in mining investment, published by Reuters. 7     This method is used to increase oil production. It changes the properties of the hydrocarbons, restores formation pressure and enhances oil displacement in the reservoir. Using EOR, oil companies can recover 30% to 60% of the original oil level in the reservoir.  Please see Enhanced Oil Recovery published by the US Department of Energy. 8    Please see the Reuter’s column CO2 emission limits and economic development. 9    Please see World Oil’s U.S. LNG players tout carbon capture in bid to boost green image. 10   Please see IEA’s Special Report on Carbon Capture Utilisation and Storage, published as a part of the Energy   Technology Perspective 2020.  11    See footnote 1 above. 12    Please see Cost of polluting in EU soars as carbon price hits record €50 by the Financial Times. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights The US is only one deflationary shock away from a European level of bond yields. On a multi-year horizon, a deflationary shock is a near-certainty. The shock will be deflationary, because even if it starts inflationary, it will quickly morph into deflationary. The reason is that the sharp backup in bond yields resulting from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. Hence, the US 30-year bond will ultimately deliver an absolute return approaching 100 percent, in absolute terms… …and relative to core European and Japanese bonds. Fractal trade shortlist: Stocks to consolidate versus bonds; Commodities look dangerously frothy; Buy USD/CAD. Feature Chart of The WeekThe Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks Ten years ago, 30-year bond yields in the US, UK and Germany stood at near-identical levels, around 3 percent. Today though, those yields are widely dispersed: the US at 2.3 percent, the UK at 1.3 percent, and Germany at 0.3 percent. What happened? In 2012, the German bond yield decoupled from the UK and the US, because the deflationary shock from the euro debt crisis was focussed in the euro area. Then, in 2016, the UK bond yield decoupled from the US, because the deflationary shock from Brexit was focussed in the UK and EU27 (Chart Of The Week). The ‘Shock Theory’ Of Bond Yields Welcome to a new concept – the ‘shock theory’ of bond yields. According to this theory, the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that the economy has suffered. Each successive deflationary shock takes the bond yield to a lower structural level until it can go no lower (Chart I-2). Chart I-2Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Since 2011, US, UK and German bond yields have decoupled because the US has suffered the legacies of one fewer deflationary shock than the UK, and two fewer deflationary shocks than Germany. But the important corollary is that the US is only one deflationary shock away from a European level of bond yields. When that deflationary shock arrives and the US 30-year bond yield reaches the recent low achieved in the UK, it will equate to a price gain of over 50 percent. And if the yield reaches the recent low achieved in Germany, it will equate to a price gain of well over 100 percent. Many people say that such gains are impossible. Yet ten years ago these same people were saying that UK and German long-duration bonds could never reach near-zero yields, and look what happened! Our high-conviction view is that the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. The simple reason is that another deflationary shock is just a matter of time away. Long-Term Investors Must Always Plan For A Shock Most strategists and investors claim that shocks, such as the pandemic, are inherently unpredictable, and therefore that you cannot plan for them. We disagree. Yes, the timing and nature of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the statistical distribution of shocks is highly predictable. What constitutes a shock? There is no established definition, so our definition is any event that causes the long-duration bond price in a major economy to rally or slump by at least 25 percent.1 (Chart I-3) Using this definition through the last 50 years, we can say that the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the statistical distribution of the time between shocks is Exponential (3.33). Chart I-3A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years It follows that in any ten-year period, the likelihood of suffering a shock is a near-certain 96 percent (Chart I-4). And even in any five-year period, the likelihood of a shock is an extremely high 81 percent. Chart I-4On A Multi-Year Horizon, A Shock Is A Near-Certainty For many people, this creates a cognitive dissonance. Even though a shock is a near-certainty, they cannot visualise its exact nature or timing, so they resist planning for it. Yet long-term investors must always plan for shocks. Not to do so is unforgiveable. An Inflationary Shock Will Quickly Morph Into A Deflationary Shock The crucial question is, will the next shock be deflationary, or inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if the shock starts as inflationary, it will quickly morph into deflationary. The simple reason is that the sharp backup in bond yields that would come from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. The 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. As prices doubled almost everywhere, the value of global real estate surged by $150 trillion (Chart I-5), of which $75 trillion was due to the valuation uplift from lower bond yields (Chart I-6). To put this into context, lower bond yields have boosted the value of global real estate by the equivalent of world GDP! Chart I-5In The 2010s Housing Boom, The Value Of Global Real Estate Surged By $150 Trillion… Chart I-6…Of Which $75 Trillion Was Due To Lower Bond Yields Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. The starting valuation needed to generate a given real return during an inflationary shock is much lower than during price stability. For example, for equities in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But in the inflation shock of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to halve to 7 (Chart I-7). Chart I-7In The 1970s Inflationary Shock, Valuations Collapsed How much can bond yields rise before undermining the value of global real estate? Over the past decade the global rental yield has not been able to deviate from the global long-duration bond yield by more than 100 bps.2 Given that the bond yield is already around 25 bps above the rental yield, we deduce that the long-duration bond yield can rise by no more than 75 bps before global real estate prices start getting hurt (Chart I-8).  Chart I-8The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt To repeat our key structural recommendation, the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. Candidates For Countertrend Reversal This week we note that the rally in stocks versus bonds (MSCI All Country World versus 30-year T-bond) is likely to consolidate in the coming months – given the fragility in the 260-day fractal structure similar to previous turning points in 2008, 2010, 2013, and 2020 (Chart I-9). Chart I-9The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months We also repeat our warning to steer clear of commodities. The rally in all commodities is becoming dangerously frothy, displaying the extremes of fractal fragility seen in 2008. (Chart I-10and Chart I-11). Chart I-10The Rally In Commodities Is Becoming Dangerously Frothy... Chart I-11...Displaying The Extremes Of Fractal Fragility Seen In 2008 A good trade right now is to short the Canadian dollar. Based on the loonie’s composite fractal structure, a lot of good news is already priced in, including the dangerously frothy commodity markets and the Bank of Canada’s (hawkish) taper of asset purchases. As such we expect the Canadian dollar to reverse in the coming months (Chart I-12). Chart I-12Short The Canadian Dollar Go long USD/CAD, setting a profit-target and symmetrical stop-loss at 3.7 percent. Dhaval Joshi Chief Strategist Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 Here, the global long-duration bond yield is defined as the average of the 30-year yields in the US and China. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations