Commodities & Energy Sector

Highlights There are tentative signs that US growth outperformance is ebbing. The recovery in the manufacturing sector abroad is already taking leadership from the US. This trend will soon rotate to the service sector. As such, long-term investors should begin to accumulate the euro on weakness. The Canadian economy is improving faster than our February assessment. This suggests the CAD could outperform sooner rather than later. Feature Chart I-1The Euro Drives The DXY Relative Growth, The Euro, And The Loonie Relative Growth, The Euro, And The Loonie The US economy has been the growth outperformer this year. As such, yields have been rising faster in the US and the dollar has caught a bid. Since the start of the year, the DXY index has retraced 2.5% of its yearly losses against developed market currencies. Meanwhile, the rally has been a broad-based one with the euro, yen and Swedish krona taking the brunt of the decline (Chart I-1). Our bias is that growth outperformance will rotate from the US to the rest of the world later this year. This should hurt the dollar and benefit procyclical currencies. This week, we look at the euro and loonie, two currencies that should benefit from this shift. EUR/USD And The Manufacturing Cycle The relationship between bond yields and the economy is circular. Long bond yields can be regarded as a key signaling mechanism about the growth prospects of an economy. At the same time, bond yields directly affect financial conditions, especially when they rise too far too fast. From the point of view of short-term currency forecasting, determining the tipping point at which rising yields become restrictive could be extremely beneficial in forecasting relative economic growth. Chart I-2 shows that whenever the relative bond yield between the US and the euro area rises by 1%, near-term relative growth subsequently tips in favor of the latter, with a lag of about 12 months. This is important since the correlation between EUR/USD and relative growth is quite strong in the short term (Chart I-3). As such, while the rise in yields between the US and the euro area can hurt EUR/USD in the short term, it will begin to benefit relative euro/US growth in the longer term. Chart I-2Relative Bond Yields And The Manufacturing Cycle Relative Bond Yields And The Manufacturing Cycle Relative Bond Yields And The Manufacturing Cycle Chart I-3Economic Data Is Surprising To The Upside In The Euro Area Economic Data Is Surprising To The Upside In The Euro Area Economic Data Is Surprising To The Upside In The Euro Area Bond Flows And Other Market Signals Despite the increase in US Treasury yields, we have not seen higher European purchases of US bonds this year (Chart I-4). During the dollar bull market from 2011 to 2020, there was a direct correlation between rising US yields and higher Treasury purchases. One difference this time around is that other safe-haven bond markets like Canada, Australia, New Zealand and even the UK, are sporting attractive yields today. US yields have not risen much against other G10 countries in aggregate. This will continue to dent the extent to which the euro can fall. On the flipside, the upside to the euro could be quite substantial. From a purchasing parity perspective, the euro can rise 15% just to reset its discount relative to the US. PPP adjustments tend to take several years, but if the US continues to pursue inflationary policies, then by definition, the fair value of the euro will also rise (Chart I-5). Chart I-4Europeans Have Not Been Increasing Treasury Holdings Europeans Have Not Been Increasing Treasury Holdings Europeans Have Not Been Increasing Treasury Holdings Chart I-5The Euro Remains Slightly ##br##Undervalued The Euro Remains Slightly Undervalued The Euro Remains Slightly Undervalued Other cyclical factors also suggest that the euro could experience a coiled-spring rebound. Copper prices have surged this year and the traditional relationship with the euro has been offside (Chart I-6). While copper is benefiting from a move away from carbon towards cleaner electricity, the euro can benefit as well. European economies have decades of experience in renewable technology and could begin to see meaningful inflows into these sectors once investment capital is deployed. This makes the Bloomberg forecast of EUR/USD at 1.23 at the end of 2022 too pessimistic (Chart I-7). Chart I-6The Euro Could Have A Coiled-Spring Rebound Soon The Euro Could Have A Coiled-Spring Rebound Soon The Euro Could Have A Coiled-Spring Rebound Soon Chart I-7Sentiment On The Euro Has Been Slightly Reset Sentiment On The Euro Has Been Slightly Reset Sentiment On The Euro Has Been Slightly Reset Finally, we are short EUR/JPY as a tactical hedge with tight stops at 131. We are also lifting our limit-buy on the EUR/USD from 1.15 to 1.16. The Canadian Recovery Is Accelerating Chart I-8The Canadian Business Survey Outlook Was Encouraging The Canadian Business Survey Outlook Was Encouraging The Canadian Business Survey Outlook Was Encouraging The Canadian recovery is taking shape faster than our February assessment, which the latest Business Outlook Survey corroborated. Both investment intentions and future sales growth were quite strong, with the former hitting a multi-decade high (Chart I-8). Notably: Two-thirds of firms see sales exceeding pre-pandemic levels; most firms stated that the second wave is having less or no impact to sales, compared to the first; and capacity constraints remain high in certain industries, but overall inflationary concerns remain relatively subdued. The robustness of the survey took us by surprise, given that a second wave of infections is raging, and most of the country is under lockdown. That said, the strength in investment spending is becoming a key theme in a global context, suggesting Canada could see significant FDI flows in the coming years. Markets have started pricing in a faster pace of rate hikes in Canada (Chart I-9). This has been a rare occurrence over the last decade and, together with our Global Fixed Income Strategy colleagues, we still believe there is less of a chance that Canada leads the hiking cycle. However, this could change if momentum in the economy allows it to surpass US growth. Chart I-9Markets Are Pricing In Faster Hikes In Canada Markets Are Pricing In Faster Hikes In Canada Markets Are Pricing In Faster Hikes In Canada The IMF estimates that Canadian real GDP growth will be 5% this year and 4.7% next year. Growth could be much stronger than these levels, according to the Bloomberg Nanos Confidence Index (Chart I-10). Chart I-10Canadian GDP On The Mend Canadian GDP On The Mend Canadian GDP On The Mend The employment report has improved tremendously since our February assessment (Chart I-11). Looking at the sub-components of the BoC Monitor, the weakness was centered on economic variables. This is changing, as the Canadian unemployment rate is falling faster than the US unemployment rate (Chart I-12). That is a bullish development for the CAD. Chart I-11The Canadian Jobs Recovery Is Robust The Canadian Jobs Recovery Is Robust The Canadian Jobs Recovery Is Robust Chart I-12Canadian Employment Catching Up To The US Canadian Employment Catching Up To The US Canadian Employment Catching Up To The US The Canadian housing market is heating up. Overall, house prices are up 10% with many cities well exceeding these levels (Chart I-13). The path for Canadian housing prices has been as follows: government support and macro prudential measures leading to a convergence in prices between low- and high-priced cities. Specifically, Vancouver (and to a certain extent, Toronto) are seeing softer pricing growth, while other cities recover. However, as prices start to deviate away from nominal incomes in lower-priced cities, the risk of wider macro prudential measures greatly increases. The second point is crucial, since the rise in Canadian home prices has been more pronounced than in other countries, such as Australia or the US. This means that both rising indebtedness and falling affordability are likely to present a key macro risk to the Canadian economy. Residential construction is a non-negligible part of the Canadian economy (Chart I-14). Chart I-13The Canadian Housing Market Has Heated Up The Canadian Housing Market Has Heated Up The Canadian Housing Market Has Heated Up Chart I-14Residential Construction Is Booming Residential Construction Is Booming Residential Construction Is Booming Bottom Line: Recent developments are increasing the odds that the Bank of Canada hikes rates sooner rather than later. This will allow further gains in the CAD. The CAD And Oil Crude oil prices are another hugely important driver for the CAD. In fact, for most of this year, interest rates have not been an important factor as the BoC faded any near-term improvement in the Canadian outlook. The Covid-19 crisis together with slow vaccination progress also hurt the recovery, putting the brakes on an appreciating loonie (Chart I-15). Our commodity strategists predict that Brent crude will hit $75 in 2023. This is higher than the forward markets are discounting. Rising forward prices will be synonymous with a higher CAD. However, Canada sells the Western Canadian Select (WCS) blend, which has historically traded at a significant discount to Brent or WTI (Chart I-16). Rising environmental standards hurt Canada, since WCS has a higher sulphur content. Pipeline capacity also remains a major bottleneck to getting Canadian crude to US refineries. Chart I-15The Loonie Has Lagged The Loonie Has Lagged The Loonie Has Lagged Chart I-16Canadian Oil Prices Could Lag The Recovery Canadian Oil Prices Could Lag The Recovery Canadian Oil Prices Could Lag The Recovery The redeeming feature this time around is that the correlation between the CAD/USD and crude oil prices is rising faster than for other currencies, as the US begins to embark on significant infrastructure projects (Chart I-17). Around 50% of US oil imports come from Canada. The Covid-19 crisis also slowed US oil production relative to Canada, which has helped increase the correlation between oil prices and the currency. Portfolio flows into Canada have been accelerating this year, benefitting oil stocks and the loonie. Chart I-17Sensitivity Of USD/CAD To Oil Has Increased Sensitivity Of USD/CAD To Oil Has Increased Sensitivity Of USD/CAD To Oil Has Increased Investment Conclusions Chart I-18The CAD Is Cheap The CAD Is Cheap The CAD Is Cheap The CAD remains cheap. It is trading at one standard deviation below its long-term mean, on a real effective exchange rate basis (Chart I-18). A return to the mean would generate about 10% upside. Our PPP model is less bullish, suggesting the loonie is cheap by about 5%. This still puts 84-85 cents within striking distance. Should the nascent Canadian recovery morph into a genuine acceleration, the CAD could rally even higher.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 US economic data has been robust this week:         CPI in March rose 2.6% year-on-year and 0.6% month-on-month, both exceeding expectations. PPI in March came in at 4.2% year-on-year and 1% month-on-month, beating expectations. The Empire Manufacturing survey staged a meaningful rebound from 17.4 to 26.3 in April. Retail sales were particularly strong, coming in at 9.8% month-on-month in March. The NAHB housing market index remained strong at 83 in April.  The DXY Index fell by 0.5% this week. The drop in bond yields was surprising, given robust data. This is likely a signal that bond short positions are becoming a crowded trade. The DXY index is rolling over in April; a trend that supports its seasonal pattern. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been mildly positive: Retail sales grew by 3% month-on-month in February versus the expected 1.7%. ZEW Economic Sentiment for both Germany and the EU in April came in lower than forecast. Industrial production fell by 1% in February over the prior month. German CPI came in at 0.5% month-on-month, in line with forecasts. The euro rose by 0.5% against the dollar this week, making this a second week of appreciation. The new Covid-19 wave may be a drag on EUR/USD in the near term, but this has also reset sentiment and positioning indicators. Our intermediate-term indicator has rolled over substantially, which is bullish from a contrarian perspective. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 JapaneseYen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Data out of Japan have been mixed: Machinery orders recorded another month of decline, falling by 8.5% month-on-month in February versus an expected 2.8% increase. However, more positively, machine tool orders grew by 65% year-on-year in March. PPI in February came in at 0.8% month-on-month, better than expectations. The Japanese yen rose by 0.4% against the US dollar this week and remains one of the strongest G10 currencies in April. Our intermediate-term indicator has collapsed and speculators are net short the currency. We remain short EUR/JPY as a portfolio hedge. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been mildly positive: February GDP rose 0.4% versus the prior month, slightly falling short of the expected 0.6% rise. Both the industrial and manufacturing production and the construction output exceeded expectations in February, growing at 1%, 1.3%, and 1.6% month-on-month. The trade deficit with the EU increased to 16.4B in February. The British pound rose by 0.3% against the US dollar this week, ranking in the middle among G10 currencies and flat against the Euro. We exited our short EUR/GBP trade last week to take profit on UK’s vaccination success and expected catch up phase for other economies. The elevated net speculative positioning on the pound also makes us neutral.  Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia were strong: NAB business conditions came in at 25 in March versus 17 in February. The Westpac Consumer Confidence Index for April rose 6.2% month-on-month to 118.8, highest since August 2010.  The labor recovery remains on track. 71K new jobs were added in March versus expectations of 35K. The unemployment rate also fell from 5.8% to 5.6%. The Australian dollar remained flat against the US dollar this week. However, the recent robust data, soaring terms of trade, and high bond yields make AUD/USD a suitable recovery trade. That said, given Mexico’s proximity to the US where recent economic data are strong, we are short the AUD/MXN pair. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: RBNZ held the official cash rate at 0.25% and its asset purchase program steady against a backdrop of a heated housing market, citing uncertainty over the outlook for growth. The NZIERB Business Confidence came in at -13% for Q1 versus -6% in Q4, a first decline in four quarters. The New Zealand dollar remained flat against the US dollar this week. On the day of the rate announcement, NZD rallied while the OIS curve flattened, which is a perplexing development. We believe the OIS curve had the appropriate response. Near term upside risk for Kiwi is the planned travel bubble with Australia. We are long the AUD/NZD. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data out of Canada have been strong: The Bank of Canada Business Outlook Survey was robust. The sentiment indicator recorded 2.87 in Q1, up from 1.3 in Q4 and highest since 2018. The March employment report was blockbuster. There were 303K new jobs versus an expectation of 100K. The split between part-time and full-time was healthy, 175K versus 128K. This brought down the unemployment rate to 7.5% in March, beating both forecasts and the February reading of 8.2%. The Canadian dollar rose by 0.3% against the US dollar this week. We spend some time in the front section discussing the Canadian dollar, which could be a little vulnerable in the short term, but could touch 84 cents in the coming 12-months. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: The unemployment reading was 3.3% in March, lower than both the forecast and prior month. The Swiss franc was flat against the US dollar this week, remaining a top performer amongst the G10 currencies in April. As we indicated in last week’s report, the Franc may be due for a rebound after its underperformance in the first three months this year. While the CHF may continue its appreciation against the US dollar, we are long EUR/CHF on valuations concern, but are maintaining tight stops at 1.095. Our USD/CHF intermediate-term indicator is also due for a reversal. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The recent data out of Norway have been mixed: GDP in February fell by 0.5% month-on-month. House prices increased by 3.4% quarter-on-quarter in Q1. March CPI came in at 3.1% year-on-year, versus expectations of a 3.4% increase. CPI disappointment was driven mainly by a 0.6% month-on-month decline in consumer goods prices. The Norwegian krone remained flat against the US dollar this week. Despite the Norges Bank’s expected rate hike this year, the earliest amongst the G10 nations, the NOK may see near term downside risks given the weak inflation data this month and the potential weakening in oil prices due to renewed virus lockdowns globally. Strategically we remain long NOK along with SEK for an eventual decline in the dollar.    Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The recent inflation data out of Sweden have been strong: The CPIF measure, favored by the Riksbank, rose 1.9% year-on-year versus the 1.5% increase in February. The rise was only was 1.4% ex-energy, but most inflation measures have rebounded powerfully from the 2020 lows. The Swedish krona, up by 1.4% against US dollar this week, was a top performing G10 currency both this week and in April. The 5-year and 10-year inflation swaps remain well anchored above the 2% level, suggesting markets are not regarding the increase in Swedish inflation as transitory. This could bring forward rate hike expectations. The higher 2-year real yield in Sweden versus US, due to higher US inflation, will also support the SEK. However, new Covid-19 cases remain a concern. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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

Dear Client, Next week I will be hosting a series of Roundtable discussions with BCA’s clients in both Europe and Asia. Our next report published on April 28th will be a recap of my observations from these meetings. Best regards, Jing Sima China Strategist Highlights The sharp uptick in Chinese producer prices should be transitory, unlikely to trigger a policy response. There are two scenarios under which Chinese manufacturers’ profit margins will benefit: either Chinese exporters will raise export prices and pass input costs onto American customers, or the RMB will depreciate versus the US dollar and commodities prices will experience a setback. The second scenario is more likely in the next 3-6 months. After a pandemic-driven boost in 2020, US imports from China will likely moderate in the second half of 2021 and into 2022. President Biden’s grand infrastructure spending plan, even if approved later this year, will not be a game changer for China’s exports or economy. The strength in the USD may intensify in the near term, and Chinese policymakers will be happy to allow the RMB to depreciate mildly. Stay underweight Chinese stocks. Feature Last week’s China’s producer price index (PPI) was more elevated than the market expected. However, it does not warrant a policy response, given that the increase was mostly driven by supply constraints rather than an overheating domestic economy. Chinese manufacturers have had a tough time passing on mounting input prices to customers, which raises the question about how profit margins will be maintained. For exporters, the answer may be a combination of increasing export prices in USD terms and depreciating the RMB.  The rate of growth in US demand for Chinese export goods may moderate in the second half of 2021 and into 2022 after a pandemic-driven boost in 2020. China’s economic growth and interest rate differentials with the US will continue to narrow in the rest of this year. We expect the RMB to face headwinds against the USD, at least in the next quarter or two. Meanwhile, global investors should continue to underweight Chinese stocks. The PBoC Will Not React To Supply-Side Price Pressures Chart 1Marchs Strong PPI Does Not Reflect An Overheating Domestic Economy Marchs Strong PPI Does Not Reflect An Overheating Domestic Economy Marchs Strong PPI Does Not Reflect An Overheating Domestic Economy Despite above-expectation readings in China’s PPI, the domestic economy shows no signs of overheating. The upside pressure on producer prices reflects the impact of both the global rally in commodities and base effects (Chart 1). In March, strength in the PPI was also accentuated by seasonality due to a resumption in construction and real estate activity following the Chinese New Year holiday. While base effects and global supply bottlenecks will continue to buoy PPI prints throughout Q2, these effects are likely transitory and would not justify a policy response. At 0.4% year-over-year in March, core CPI remains significantly below the central bank’s 3% target and does not indicate any demand-side pressure. Instead, the inability for Chinese producers to pass on higher input prices to consumers highlights the relatively subdued state of domestic demand (Chart 1, bottom panel). Chart 2Current Macro Policy Works To Cap The Upsides In Both The Price And Quantity Of Money Current Macro Policy Works To Cap The Upsides In Both The Price And Quantity Of Money Current Macro Policy Works To Cap The Upsides In Both The Price And Quantity Of Money At this point there are little signs that rising producer prices are spilling over to consumer prices. We expect Chinese authorities to continue its current policy trajectory, which intends to keep a steady interbank rate while keeping money supply growth at or below the rate of nominal GDP expansion (Chart 2). China’s Deteriorating Terms Of Trade Chinese export prices climbed slightly in USD terms, but not by enough to offset the RMB’s relentless appreciation from the second half of last year, as indicated by falling export prices in RMB terms (Chart 3). A deteriorating terms of trade (ToT), defined as export prices relative to import costs, means that Chinese producers must export a greater number of units to purchase the same number of imports (Chart 4).  The declining ToT can be a powerful deflationary force for China’s manufacturing sector. Chart 3Chinese Export Prices Are Rising In USD Terms But Falling In Local Currency Terms Chinese Export Prices Are Rising In USD Terms But Falling In Local Currency Terms Chinese Export Prices Are Rising In USD Terms But Falling In Local Currency Terms Chart 4Terms Of Trade Have Been Falling Terms Of Trade Have Been Falling Terms Of Trade Have Been Falling Chart 5Chinese Output Prices Lead US Consumer Inflation By A Year Chinese Output Prices Lead US Consumer Inflation By A Year Chinese Output Prices Lead US Consumer Inflation By A Year While there are limited choices for China to improve its ToT, manufacturers could raise export prices in USD terms and “recycle” cost-push inflation back to the US. Chinese PPI normally leads US consumer inflation by 12 to 18 months (Chart 5). Hence, it is possible that the US will see import prices from China picking up more momentum by the middle of next year. The RMB’s performance is a key macro driver for manufacturing-related output prices. A depreciation in the RMB can be a meaningful reflationary force for manufacturers. There has been a clear negative correlation between the trade-weighted RMB and Chinese manufacturers' output prices and industrial profits, as shown in Chart 6. In this scenario, the USD will continue to appreciate against the RMB and possibly emerging market currencies, a headwind to global trade (Chart 7). Chart 6A Falling RMB Can Be Reflationary To Chinese Producers A Falling RMB Can Be Reflationary To Chinese Producers A Falling RMB Can Be Reflationary To Chinese Producers Chart 7A Stronger USD Will Be Headwinds For Global Trade A Stronger USD Will Be Headwinds For Global Trade A Stronger USD Will Be Headwinds For Global Trade Maintaining a strong RMB can partly mitigate the pain stemming from escalating commodity import prices.  However, in our view it is the least preferred option by policymakers. In previous cycles a rapidly strengthening RMB did not have a major impact on Chinese exporters' competitiveness, mainly because declines in commodities prices effectively offset a rising RMB (Chart 8 and Chart 9). Therefore, Chinese exporters did not need to boost prices in USD terms to maintain their profit margins. Chart 8RMB Appreciations Did Not Hurt Chinas Share In Global Trade RMB Appreciations Did Not Hurt Chinas Share In Global Trade RMB Appreciations Did Not Hurt Chinas Share In Global Trade Chart 9...Because Declines In Commodities Prices Were Able To Offset A Rising RMB ...Because Declines In Commodities Prices Were Able To Offset A Rising RMB ...Because Declines In Commodities Prices Were Able To Offset A Rising RMB Bottom Line: Chinese exporters can either raise prices and pass the inflation onto American customers, or the PBoC will allow further depreciation in the RMB to maintain Chinese producers’ competitiveness. Appreciating the RMB is the least preferred option. Don’t Count On A US Buying Spree  Market participants in China are pricing in large windfalls from the US$1.9 trillion American Rescue Plan and proposed US$2.4 trillion American Jobs Plan.1 A positive export tailwind in Q1 this year boosted China’s economic activity beyond what measures of domestic money and credit would have predicted, as shown in Chart 10. However, given the strongly positive relationship between the export sector and real investment in China, it is concerning that any deceleration in US demand for Chinese export goods would seriously challenge the sanguine view for China’s economy this year (Chart 11). Chart 10Export Strength Appears To Be Propping Up The LKI Export Strength Appears To Be Propping Up The LKI Export Strength Appears To Be Propping Up The LKI Chart 11China's Export Sector Is Highly Investment-Intensive From Deflation To Inflation … What’s Next? From Deflation To Inflation … What’s Next? Moreover, US demand for Chinese export goods is subject to several countervailing forces, at least in the second half of 2021: The USD currently benefits from widening real interest differentials and stronger US growth relative to the rest of the world. For the next quarter or two, persistent strength in the USD and US Treasury yields will be headwinds to global trade and may cause a temporary setback for the global manufacturing sector (Chart 7 on Page 4). Residential and business investment in the US may not regain much vigor despite large stimulus checks. Our colleagues at BCA US Investment Strategy expect US residential investment to match the long-run trend growth, but the increase will be largely offset by below-trend growth in non-residential investment. More working-from-home options will continue to drive demand for single-family homes in the suburbs and beyond. On the other hand, demand will suffer for office space in central business districts and dwellings in urban centers. Brick-and-mortar retail construction is also going to crater. Consumption for goods in the US may also see below-trend growth in the second half of 2021 and into 2022, whereas the service sector will benefit most from the coming recovery in US business and social activities. Table 1 shows that goods spending rose in 2020 despite an overall decline in consumption, because households dramatically shifted their consumption into goods from services. As such, 2020’s pandemic-driven dividend for Chinese exporters is likely to become a drag on tradeable goods exports to the US in 2021 and/or 2022. Table 1US Consumer Spending Gap Is Almost Entirely On The Services Side From Deflation To Inflation … What’s Next? From Deflation To Inflation … What’s Next? It is also important for investors to put the US$2.4 trillion infrastructure spending budget proposed in the American Jobs Plan into prospective. The US lags far behind China in infrastructure spending. In the past 10 years, US public infrastructure investment (federal and state combined) has declined to an average of about $450 billion.2 This compares with China’s US $1.9 trillion yearly spending on infrastructure (Chart 12). China currently consumes seven to eight times more industrial metals than the US (Chart 13). As such, even if the US infrastructure investment plan will be approved later this year, it is unlikely to be a game changer for global commodity prices or Chinese exports. Chart 12Infrastructure Spending, China Vs. The US From Deflation To Inflation … What’s Next? From Deflation To Inflation … What’s Next? Chart 13US Consumption Of Industrial Metals Is Too Small Relative To China From Deflation To Inflation … What’s Next? From Deflation To Inflation … What’s Next? The proposed US$1.2 trillion spending on the US nation’s roads, bridges, green spaces, water, electricity, and universal broadband will be spread over the next eight years.  The additional $150 billion per annum to the US public infrastructure investment will only boost the US spending from 24% to about 32% of China’s annual infrastructure investment. Furthermore, the fiscal multiplier effect from the extra public spending on investment from the US private sector and overall economy may not be as positive as the market has priced in, depending on the size of corporate tax hikes in the final bill. Bottom Line: After a pandemic-driven boost in 2020, growth in US imports from China will likely moderate in the second half of 2021 and into 2022. The proposed infrastructure spending plan in the US will benefit Chinese exports, but the magnitude of the windfall may be disappointing. Investment Implications As discussed in a previous report, rising US bond yields will have a muted effect on their Chinese counterparts. Tightened regulations on the real estate industry and a new round of environmental protection laws in China will continue to suppress the domestic credit demand.  As a result, interest rate differentials between China and the US will continue to narrow. The strength in the USD has not run its course and the RMB will face slight depreciation pressures in Q2 and possibly into Q3. A declining RMB will provide reflationary benefits to China’s industrial profits, but with about a six-month time lag. In the meantime, we recommend global investors to continue underweighting Chinese stocks (Chart 14A and 14B). Chart 14AContinue Underweighting Chinese Stocks Continue Underweighting Chinese Stocks Continue Underweighting Chinese Stocks Chart 14BContinue Underweighting Chinese Stocks Continue Underweighting Chinese Stocks Continue Underweighting Chinese Stocks   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1According to the OECD, recent US stimulus will boost US GDP growth by almost 3 percentage points in the first full year (from 2021Q2 to 2022Q2). The knock-on effect from the stimulus on other economies is projected to be significant, including a half percentage point addition to China’s GDP during the same period. 2The Congressional Budget Office estimated that combined federal, state and local spending on infrastructure was (in 2019 dollars) $441 billion as of 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Inflation: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Inflation-Linked Bond Allocations: ILB valuations, however, are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB. Feature Chart of the WeekMarkets Remain Unconcerned About An Inflation Overshoot Markets Remain Unconcerned About An Inflation Overshoot Markets Remain Unconcerned About An Inflation Overshoot The global reflation trade over the past year has been highly rewarding to investors. Equity and credit markets worldwide have delivered outstanding returns on the back of highly stimulative monetary and fiscal policies implemented to deal with the negative economic effects of COVID-19. The global INflation trade has also paid off for investors in inflation-linked bonds (ILBs), which have outperformed nominal government debt across the developed economies dating back to last spring. The rising trend for global inflation breakevens remains intact, but is approaching some potential resistance points. A GDP-weighted average of 10-year breakeven inflation rates among the major developed economies is just shy of the 2% level that has represented a firm ceiling over the past decade (Chart of the Week). At the same time, the Bloomberg consensus forecast for headline CPI inflation for that same group of countries calls for an increase to only 1.8% by year-end before slowing to 1.7% in 2022. The latest forecasts from the IMF are similar, calling for headline inflation in the advanced economies to reach 1.6% in 2021 and 1.7% in 2022. If those modest forecasts for realized inflation come to fruition, then there is likely not much more upside in inflation breakevens, in aggregate. Country selection within the ILB universe will become more important over the next 6-12 months, as divergences in growth, realized inflation and central bank reactions will lead to a more heterogeneous path for global inflation breakevens. Underlying Inflation Backdrop Still Supports Rising Breakevens On a total return basis, ILBs enjoyed an extended run of success prior to this year. The cumulative total return of the asset class (in local currency terms) between 2012 and 2020 was a whopping 61% in the UK, 25% in Canada, 22% in the US and 21% in the euro area (aggregating the individual countries in the region with inflation-linked bonds). However, the absolute performance of ILBs has been more disperse on a country-by-country basis so far in 2021. ILBs are down year-to-date in Canada (-6.2%), the UK (-5.0%) and the US (-1.4%). On the other hand, euro area ILBs have delivered a positive total return of +0.5% so far in 2021. Real bond yields have climbed off the lows in the US, UK and, most notably, Canada where the overall index yield on the Bloomberg Barclays inflation-linked bond index is now in positive territory for the first time since before the pandemic started (Chart 2). At the same time, real bond yields have been drifting lower in the euro area. These real yield moves are related to shifting perceptions of central bank responses to the global growth upturn. For example, pricing in overnight index swap (OIS) curves have pulled forward the timing and pace of future interest rate increases in the US and Canada – i.e. real policy rates will become less negative - while there has been comparatively little change in euro zone rate expectations. While the absolute returns for ILBs have become less correlated, the relative trade between nominal and inflation-linked government bonds in all countries remains intact. 10-year breakeven inflation rates have been steadily climbing in the US and UK, while depressed Japanese breakevens have crept modestly higher (Chart 3). Even Europe, where inflation has remained subdued for years, has seen a significant shift higher in inflation breakevens. (Chart 4). The turn in breakevens has occurred alongside a major change in investor perceptions of future inflation, with surveys like the ZEW showing an overwhelming majority of financial professionals expecting higher inflation in the US, Europe and the UK. Chart 2A Fading Bull Market In Inflation-Linked Bonds A Fading Bull Market In Inflation-Linked Bonds A Fading Bull Market In Inflation-Linked Bonds Chart 3A Solid Recovery In Inflation Expectations A Solid Recovery In Inflation Expectations A Solid Recovery In Inflation Expectations Chart 4European Inflation Expectations Starting To Normalize European Inflation Expectations Starting To Normalize European Inflation Expectations Starting To Normalize Inflation forecasts have shifted in response to faster global growth expectations on the back of vaccine optimism and aggressive US fiscal stimulus. Yet inflation forecasts remain modest compared to the huge growth figures expected for 2021 and 2022. In its latest World Economic Outlook published last week, the IMF upgraded its global real GDP forecast to 6.0% for 2021 and 4.4% for 2022. This represented an increase of 0.5 and 0.4 percentage points, respectively, from the last set of forecasts published back in January. While growth upgrades occurred across all major developed and emerging economies, the biggest upgrades came in the US and Canada, for both 2021 and 2022. As a result, the IMF projects the output gap in both countries to turn positive over 2022 and 2023, and be nearly closed in core Europe, Australia and Japan (Chart 5). The IMF is not projecting a major inflation surge on the back of those upbeat growth forecasts, though. While headline inflation in the US is expected to climb to 2.3% in 2021 and 2.4% in 2022, the same measure in Canada is only projected to rise to 1.7% and 2.0% over the same two years. European inflation is expected to remain subdued, reaching only 1.4% this year and drifting back to 1.2% in 2022 despite real GDP growth averaging 4.1% over the two-year period. The IMF attributes the benign inflation outcomes, even in the face of booming growth rates and the rapid elimination of output gaps, to the structural disinflationary backdrop for so-called “non-cyclical” inflation (Chart 6). The IMF defines this as the components of inflation indices that are less sensitive to changes in aggregate demand. The IMF estimates show that the contribution from non-cyclical components to overall inflation in the advanced economies had fallen to essentially zero at the end of 2020. Chart 5A Big Expected Narrowing Of Output Gaps How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart 6Non-Cyclical Components Still Weighing On Global Inflation Non-Cyclical Components Still Weighing On Global Inflation Non-Cyclical Components Still Weighing On Global Inflation There is considerable upside risk for the more cyclical components of inflation that could result in inflation overshooting the IMF projections (Chart 7). Chart 7Cyclical Backdrop Is Inflationary Cyclical Backdrop Is Inflationary Cyclical Backdrop Is Inflationary For example, in the US, the Prices Paid component of the ISM Manufacturing index remains elevated at post-2008 highs, while the year-over-year change in the Producer Price Index soared to 6% in March. Across the Atlantic, the European Commission business and consumer surveys have shown a big surge in the net balance of respondents expecting higher inflation in manufacturing and retail trade. Previous weakness in the US dollar and surging commodity prices are playing a major role in this rapid pick-up in price pressures seen in many countries. Given the current backdrop of strong global growth expectations, with actual activity accelerating as vaccinations increase and more parts of the global economy reopen, inflation pressures are unlikely to fade in the near term. With realized inflation rates set to spike due to base effect comparisons to the pandemic-fueled collapse one year ago, the upward pressure on global ILB inflation breakevens will persist in the coming months – especially with breakevens still below levels that would prompt central banks to turn less dovish sooner than expected. Bottom Line: The case for maintaining a strategic overall allocation to inflation-linked bonds (ILBs) versus nominal government debt in dedicated global fixed income portfolios remains intact. Global growth expectations are accelerating as vaccinations increase, spare capacity is increasingly being absorbed across the developed world and central banks (led by the Federal Reserve) continue to show no inclination to tighten policy anytime soon. Assessing Value In Developed Market Inflation-Linked Bonds Chart 8USD Outlook Now More Mixed USD Outlook Now More Mixed USD Outlook Now More Mixed Although the current backdrop remains conducive to a continuation of the rising trend in global ILB breakevens, there are factors that could begin to slow the upward momentum. The future path of the US dollar is now a bit less certain (Chart 8). While the DXY index is still down 7.4% compared to a year ago, it is up 2.4% so far in 2021. Shorter-term real interest rate differentials between the US and the other major developed markets remain dollar-bearish. At the same time, longer-term real yield differentials have risen in favor of the US (middle panel). Furthermore, US growth is outperforming other developed economies, typically a dollar-bullish factor (bottom panel). Given the usual negative correlation between the US dollar and commodity prices, a loss of downside dollar momentum could also slow the pace of commodity price appreciation. This represents a risk to additional global ILB outperformance versus government bonds. Our GDP-weighted aggregate of 10-year ILB breakevens for the major developed economies is currently just under 2% - levels more consistent with oil prices over $80/bbl than the current price closer to $60/bbl (Chart 9). Chart 9Breakevens Consistent With Much Higher Oil Prices Breakevens Consistent With Much Higher Oil Prices Breakevens Consistent With Much Higher Oil Prices Given some of these uncertainties over the strength of any future inflationary push from a weaker US dollar and rising commodity prices, a broad overweight allocation to ILBs across the entire developed market universe may no longer generate the same strong returns versus nominal government bonds seen over the past year. With the “easy money” already having been made in the global breakeven widening trade, country allocation within the ILB universe has now become a more important dimension for bond investors to consider. To assess the relative attractiveness of individual ILB markets, we turn to a few valuation tools. Our regression-based valuation models for 10-year ILB breakevens in the US, UK, France, Italy, Germany, Japan, Canada and Australia are all presented in the Appendix on pages 14-17. The two inputs into the model are the annual rate of change of the Brent oil price in local currency terms (as a measure of shorter-term inflation pressure) and a five-year moving average of realized headline CPI inflation (as a longer-term trend that provides a structural “anchor” for breakevens based off actual inflation outcomes). We first presented these models in April 2020, but we have now made a change in response to some of the unprecedented developments witnessed over the past year.1 Despite the strong visual correlation between the level of oil prices and inflation breakevens in most countries, we chose to use the annual growth of oil prices, rather than the level, in our breakeven models. This is because we found it more logical to compare a rate of change concept like inflation (and breakevens) to the rate of change of oil. However, the oil input into our breakeven models could produce nonsensical results during periods of extreme oil volatility that did not generate equivalent swings in breakeven inflation rates. A good example of that occurred in 2016, when the annual rate of change of the Brent oil price briefly surged toward 100%, yet 10-year US TIPS breakevens did not rise above 2% (Chart 10). An even bigger swing in oil prices has occurred over the past year, with oil prices up over +200% compared to the collapse in prices that occurred one year ago. Putting such an extreme move into our US model would have pushed the “fair value” level of the 10-year TIPS breakeven to 4% - an implausible outcome given that the 10-year breakeven has never risen to even as high as 3% in the entire 24-year history of the TIPS market. Chart 10Pass-Through Of Extreme Oil Moves Has Limits Pass-Through Of Extreme Oil Moves Has Limits Pass-Through Of Extreme Oil Moves Has Limits To deal with this problem, we have truncated the rate of change of oil prices in all our breakeven models at levels consistent with past peaks of breakevens. Going back to the US example, we have “capped” the rate of change of the Brent oil price at +40%, as past periods when oil price momentum was greater than 40% did not translate into any additional increase in TIPS breakevens. We then re-estimated the model using this truncated oil price series to generate fair value breakeven levels. Chart 11A Mixed Impact Of USD Moves On Non-US Breakevens A Mixed Impact Of USD Moves On Non-US Breakevens A Mixed Impact Of USD Moves On Non-US Breakevens We did this for all eight of our individual country breakeven models and in all cases, truncating extreme oil moves improved the accuracy of the model. Interestingly, we did not truncate the downside momentum of oil prices, as there was no obvious “cut-off” point where periods of collapsing oil prices did not generate equivalent declines in breakevens. Oil prices remain the most critical short-term variable to determine ILB breakeven valuation. While it is intuitive to think that currency movements should also have a meaningful impact on inflation (both realized and expected), the effect is not consistent across countries. For example, euro area breakevens appear to be positively correlated to the euro, while Japanese breakevens rarely rise without yen weakness (Chart 11). One other factor to consider when evaluating the value of breakevens is the possible existence of an inflation risk premium component during periods of higher uncertainty over future inflation. Such uncertainty could result in increased demand for ILBs from investors driving up the price of ILBs (thus lowering the real yield) relative to nominal yielding bonds, leading to wider breakevens that do not necessarily reflect a true rise in expected inflation. A simple way to measure such an inflation risk premium is to compare market-based breakevens to survey-based measures of inflation forecasts taken from sources like the Philadelphia Fed's Survey of Professional Forecasters and the Bank of Canada’s Survey Of Consumer Expectations. The assumption here is that the survey-based measures represent a more accurate (or, at least, less biased) depiction of underlying inflation expectations in an economy. We present these simple measures of inflation risk premia, comparing 10-year breakevens to survey-based measures of inflation expectations, in Chart 12 and Chart 13. Breakevens had been trading well below survey-based measures of inflation expectations after the negative pandemic growth shock in 2020 in all countries shown. After the steady climb in global breakevens seen over the past year, those gaps have largely disappeared, with breakevens now trading slightly above survey based inflation expectations in the US, UK and Australia. Chart 12No Major Inflation Risk Premia In These Markets No Major Inflation Risk Premia In These Markets No Major Inflation Risk Premia In These Markets Chart 13Canadian & Australian Breakevens In Line With Inflation Surveys Canadian & Australian Breakevens In Line With Inflation Surveys Canadian & Australian Breakevens In Line With Inflation Surveys Chart 14Assessing The Value Of Breakevens Assessing The Value Of Breakevens Assessing The Value Of Breakevens In Chart 14, we show the valuation residuals from our 10-year ILB breakeven models, along with two other measures of potential breakeven valuation: a) the distance between current breakeven levels and their most recent pre-pandemic peaks; and b) the difference between breakevens and the survey-based measures of inflation expectations. The model results show that breakevens are furthest below fair value in France, Japan and Germany, and the most above fair value in the UK and Australia. The message of undervaluation from our models is confirmed in the other two metrics for France, Japan, Germany, Canada and Italy. The overvaluation message for Australia is consistent across all three valuation metrics, while the signals are mixed for US and UK breakevens. In Japan, while the combined signals of all three valuation metrics indicate that breakevens are far too low, the very robust positive correlation between Japanese breakevens and the USD/JPY exchange rate implies that a bet on wider breakevens requires a much weaker yen. In Canada, while the 10-year breakeven does appear cheap, the real yield has also climbed faster than any of the other countries over the past several months as markets have rapidly repriced a more hawkish path for the Bank of Canada. Recent comments from Bank of Canada officials have leaned a bit hawkish, hinting at a possible taper of its bond-buying program, as the central bank appears unhappy with the renewed boom in Canadian housing values. An early tightening of monetary conditions would likely cap any additional upside in Canadian inflation breakevens. In Europe, the undervaluation of breakevens is more compelling. The ECB is likely to maintain its dovish policy settings into at least 2023, even if growth recovers later this year as increased vaccinations lead to the end of lockdowns. As shown earlier, European breakevens can continue to rise even if the euro is also appreciating versus the US dollar, especially if growth is recovering and oil prices are rising. Euro area breakevens are likely to continue drifting higher over at least the rest of 2021. Currently in our model bond portfolio, we have allocations to ILBs out of nominal government bonds in the US, France, Canada and Italy, with no allocations in Germany, Japan, Australia or the UK. After assessing our valuation measures, we are comfortable with the ILB exposure in France and Italy and lack of positions in the UK and Australia. We still see the upside case for US breakevens, with the economy reopening rapidly fueled further by fiscal policy, and the Fed likely to maintain its current highly dovish forward guidance until much later in 2021. We are reluctant to add exposure to Japanese ILBs, despite attractive valuations, as we are not convinced that USD/JPY has enough upside potential to help realize that undervaluation of Japanese breakevens. Thus, as a new change to our model portfolio this week that reflects our assessment of ILB breakeven valuations and risks, we are closing out the exposure to Canadian ILBs and adding a new position in German ILBs of equivalent size (see the model bond portfolio tables on pages 18-19). Bottom Line: ILB valuations are no longer uniformly cheap across all countries. Real yields are now moving in a less coordinated fashion as markets try to sort out the timing and pace of eventual future central bank tightening. We recommend shifting inflation-linked bond exposure from Canada to Germany, as both markets have similar valuations but the Bank of Canada is likely to turn less dovish well ahead of the ECB.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Appendix Chart A1Our US 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A2Our UK 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A3Our France 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A4Our Italy 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A5Our Japan 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A6Our Germany 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A7Our Canada 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Chart A8Our Australia 10-Year Inflation Breakeven Model How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? Recommendations How Much More Juice Is Left In The Global Inflation Breakeven Trade? How Much More Juice Is Left In The Global Inflation Breakeven Trade? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 2US Natgas Inventories Return To Five-Year Average US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 4US LNG Exports Set Records In November And December 2020 US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely US-Russia Conflit Likely US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Copper Prices Surge As Global Storage Draws Copper Prices Surge As Global Storage Draws Chart 10 Gold Disconnected From US Dollar And Rates Gold Disconnected From US Dollar And Rates       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Cryptocurrencies are the ‘digital gold’. Long-term investors should hold cryptocurrencies and gold in inverse proportion to their volatilities. On this basis, cryptocurrencies should take around a quarter of the $15 trillion anti-fiat asset market, taking the bitcoin price to around $120,000. Own a diversified basket of cryptocurrencies, including an eco-friendlier ‘proof of stake’ cryptocurrency such as Ethereum. As cryptocurrencies take a larger share of the anti-fiat market, gold’s massive anti-fiat premium versus silver and platinum will collapse. Structural recommendation: overweight silver and platinum versus gold. Structurally underweight gold miners, both versus other miners and versus the market. Feature Feature ChartEach Time People Thought Bitcoin Was In A Bubble, They Were Wrong Each Time People Thought Bitcoin Was In A Bubble, They Were Wrong Each Time People Thought Bitcoin Was In A Bubble, They Were Wrong This Special Report presents the long-term investment case for cryptocurrencies. It is the transcript of twenty questions and answers that made up a recent conversation with a sceptical client. 1.     I am sceptical of cryptocurrencies. Specifically, I think that bitcoin is dirty, slow, volatile, and impractical. Are you going to convince me otherwise? Yes, I’m going to tell you that those criticisms are misunderstandings, or, at least, irrelevant to the long-term investment case. 2.     Ok, let me ask the $57,000 question. Is bitcoin in a bubble? No, bitcoin is not in a bubble. Though to be clear, its price could fall sharply from its current overbought position. Bitcoin’s price has collapsed by 80 percent on three separate occasions: in 2011, 2014, and 2018. Each time, people said the bitcoin bubble had burst, and each time they were wrong. Each time, bitcoin recouped its losses within a couple of years and went on to new highs. On a long-term horizon, I expect the same to happen again (Feature Chart). Cryptocurrencies Are The ‘Digital Gold’ 3.     So, what is the long-term investment case for owning bitcoin and other cryptocurrencies? Cryptocurrencies are the ‘digital gold’. So long as we have a fiat money system, there will be demand for an ‘anti-fiat’ asset that is a hedge against a debasement of the fiat money system. For decades, the dominant anti-fiat asset has been gold. But cryptocurrencies are the new kid on the block threatening gold’s dominance. So far, cryptocurrencies account for just 10 percent of the $15 trillion anti-fiat market. As this share doubles or trebles, it arithmetically requires a doubling or trebling of cryptocurrency prices. 4.     New cryptocurrencies seem to appear every day. How can the limitless number of cryptocurrencies be compared with gold, whose supply is limited? Although the number of cryptocurrencies is unlimited, the total cryptocurrency money supply is limited by the amount of energy expended to mine them. As a useful analogy, each cryptocurrency is like a separate gold miner. While there could be an unlimited number of gold miners, there could not be an unlimited supply of gold. 5.     But a cryptocurrency has no intrinsic value, right? Right, but a fifty pound note has no intrinsic value either. It’s just a bit of paper. The value of a fifty pound note – or any fiat money for that matter – is the trust that you place in the government and the central bank to maintain its value. Likewise, the value of a bitcoin is the trust that you place in the blockchain to maintain its long-term value – so it’s really like an alternative trust system to the trust you place in the fiat monetary system. In fact, the blockchain is often called ‘the trust machine’. 6.     Yet gold does have an intrinsic value. I can always melt it down and wear it as valuable jewellery, which makes it a superior anti-fiat asset, right? No, this is a misunderstanding. Gold does have an intrinsic value, but it is a small fraction of its $1700/oz price. Gold’s intrinsic value is a small fraction of its $1700/oz price. The proof comes from comparing the precious metal price ratios with their (inverse) mining ratios. For the other precious metals – silver and platinum – the price ratio lines up broadly with the mining ratio, as it should (Chart I-2). But gold is the outlier, trading at a massive premium to its mining ratio. For example, the gold/silver price ratio at 70 compares with a mining ratio of 7.5, a near tenfold premium (Chart I-3). So, most of gold’s value comes from its status as the dominant anti-fiat asset. Chart I-2Platinum To Silver Trades Broadly In Line With Its Mining Ratio Platinum To Silver Trades Broadly In Line With Its Mining Ratio Platinum To Silver Trades Broadly In Line With Its Mining Ratio Chart I-3Gold To Silver Trades At A Massive Premium To Its Mining Ratio Gold To Silver Trades At A Massive Premium To Its Mining Ratio Gold To Silver Trades At A Massive Premium To Its Mining Ratio 7.     Hasn’t the gold/silver price ratio always been this elevated? No, through the many centuries that gold and silver had equal monetary status, the gold/silver price ratio tracked its mining ratio of around 15. Gold’s massive premium arose only when it became the dominant anti-fiat asset – first, when the gold standard collapsed in 1931 and then, when the Bretton Woods ‘pseudo gold standard’ collapsed in 1971. Proving that most of the current value of gold is its value as the dominant anti-fiat asset (Chart I-4).  Chart I-4Gold’s Massive Premium Is Due To Its Status As The Dominant Anti-Fiat Asset Why Cryptocurrencies Are Here To Stay And Bitcoin Is Worth $120,000 Why Cryptocurrencies Are Here To Stay And Bitcoin Is Worth $120,000 8.     But unlike gold, cryptocurrencies trade like extreme risk-assets, so are they suitable for a conservative investor, like me? Conservative investors like you have no qualms holding gold even though it can suffer significant drawdowns, such as a 30 percent loss in 2013 and a near 20 percent loss through the past six months (Chart I-5). Of course, cryptocurrencies can suffer even bigger drawdowns, but this can be addressed by position sizing. Specifically, holding $1 of cryptocurrency for every $3 of gold will equalise the drawdown risks from the two anti-fiat assets. Chart I-5Gold Can Suffer Significant Drawdowns Gold Can Suffer Significant Drawdowns Gold Can Suffer Significant Drawdowns Countering The Counterarguments 9.     Now we come to the elephant in the room. Even if I accept that cryptocurrencies are the ‘digital gold’, mining these cryptocurrencies consumes as much energy as a small country. Isn’t this a huge problem? No, this is another misunderstanding. There is nothing wrong with using energy, and it is up to the market – rather than governments or self-proclaimed experts – to decide how to allocate our energy consumption. Remember that we are becoming less energy-intensive in other parts of our lives, so if the market deems that a certain proportion of energy consumption is well served to secure a superior anti-fiat asset, then that’s fine. Thinking more broadly, intermediation functions like banking and legal services account for around two percent of world GDP, while energy production accounts for five percent. So, if the blockchain could carry out that intermediation more efficiently and securely, then society could justify the blockchain consuming two fifths of the world’s energy. 10.   Ok, but what about the dirty energy that cryptocurrency mining consumes, and the damage it does to the environment? Yes, dirty energy is a problem but let’s address it by banning or taxing dirty energy! And let’s have a fair comparison. Gold mining might consume less energy than cryptocurrency mining, but it devastates the environment via the 99 percent of extracted ore that is dumped as waste, landscape destruction, acid mine drainage, and mercury production. Not to mention the tremendous energy needed to transport gold. None of these dirty issues apply to cryptocurrencies. Ultimately, the blockchain is a force for good because, unlike the internal combustion engine or mining, it can be a hundred percent environmentally friendly. Moreover, compared to the usual ‘proof of work’ protocol to secure a transaction, the emerging ‘proof of stake’ protocol removes the advantage to the most powerful computers, and thereby consumes much less energy. 11.    But the fiat currency system does just fine. And gold does just fine for those who want an anti-fiat currency asset. So, isn’t bitcoin just a ‘solution in search of a problem’? Almost every innovation is a ‘solution in search of a problem!’ Before aeroplanes, weren’t we doing just fine with ships and trains? And before the internet, weren’t we doing just fine with information disseminated by governments and major media and publishing companies? Then the internet decentralised and democratised information, and transformed every aspect of our lives. In the same way, the blockchain, which decentralises and democratises trust, can also transform every aspect of our lives. The same criticisms that are being thrown at the blockchain today were being thrown at the internet in the early 1990s. The same criticisms that are being thrown at the blockchain today were being thrown at the internet in the early 1990s. That the internet was slow, impractical, used mostly by criminals for nefarious purposes, that no reputable company would use it, that nobody would put their personal data or credit card details on it, and so on. I guess this shows that most people cannot comprehend an innovation until they experience its transformative impact. 12.   Ok, I’m all for innovation, but isn’t central bank digital currency a better alternative to cryptocurrency? Absolutely not! The whole point of an anti-fiat asset is that it must be completely immune to government and central bank manipulation. 13.   I still have some worries. First, can’t governments just ban cryptocurrencies? It would be something that I would expect in North Korea, but not in a liberal democracy like the UK or the US. Apart from anything else, it would be counterproductive – because the act of banning the anti-fiat asset would be the very act that would cause a surge in its demand! The better course for governments is to demonstrate, in fair competition, that fiat money is as trustworthy as anti-fiat money. 14.   Ok, what about governments taxing cryptocurrency transactions? Again, I think that the best course of action is for governments not to penalise anti-fiat money. But even if they did impose a transaction tax, it wouldn’t diminish cryptocurrencies’ anti-fiat status. After all, most people don’t own gold to carry out day-to-day transactions with it! 15.    One last worry: could quantum computing wipe out the blockchain and cryptocurrencies? The mathematical protocols would have to become orders of magnitude more difficult, but the over-arching concept of a decentralised peer-to-peer network to validate ownership and transactions would remain.  The Investment Conclusions 16.   Ok, let’s get to the investment conclusions. First, how should I value bitcoin and the cryptocurrency asset-class? The immediate question is, what share of the $15 trillion anti-fiat market should cryptocurrencies take? Our answer is that, in order to equalise drawdown risk, investors should hold cryptocurrencies and gold in inverse proportion to their drawdown magnitudes (or volatility). As cryptocurrency drawdowns tend to be three times as large as gold drawdowns, this means holding $1 of cryptocurrency for every $3 of gold (Chart I-6 and Chart I-7). Chart I-6Drawdowns Suffered ##br##By Bitcoin... Drawdowns Suffered By Bitcoin... Drawdowns Suffered By Bitcoin... Chart I-7...Tend To Be Three Times As Large As Drawdowns Suffered By Gold ...Tend To Be Three Times As Large As Drawdowns Suffered By Gold ...Tend To Be Three Times As Large As Drawdowns Suffered By Gold In other words, based on current volatilities, cryptocurrencies should take around a quarter of the anti-fiat market, or around double the current market share. Assuming a constant market size, and a uniform uplift to all cryptocurrencies, this would double all cryptocurrency prices, taking bitcoin to around $120,000. Cryptocurrencies should take around a quarter of the anti-fiat market, or around double the current market share. Of course, as cryptocurrencies become more established and their volatilities diminish, their share of the anti-fiat market can rise, taking their prices even higher.  17.   Will all cryptocurrencies succeed? No. Just as gold miners take market share from each other, cryptocurrencies will also take market share from one another. Hence, it is important to own a diversified basket of cryptocurrencies. At the very least, it is important to have some exposure to an eco-friendlier ‘proof of stake’ cryptocurrency such as Ethereum. Given its greener credentials, ‘proof of stake’ may take the dominant market share in the coming years.   18.   Will cryptocurrencies eventually replace fiat money? Not necessarily. As previously explained, fiat money and cryptocurrencies are just competing trust systems. So long as governments and central banks maintain our trust in fiat money, there is no reason to replace fiat money. 19.   Does this have any implications for inflation? Yes. With cryptocurrencies as a competing trust system, the only way for governments and central banks to maintain our trust in fiat money is not to debase its value. In other words, cryptocurrencies are the new vigilantes to prevent rampant inflation. 20.   What are the structural implications for gold and other precious metals? As cryptocurrencies take a larger share of the anti-fiat market, gold’s massive anti-fiat premium versus silver and platinum will collapse. Hence, a compelling long-term position is to overweight silver and platinum versus gold (Chart I-8). Chart I-8Structurally Overweight Silver And Platinum Versus Gold Structurally Overweight Silver And Platinum Versus Gold Structurally Overweight Silver And Platinum Versus Gold Long-term equity investors should underweight gold miners, both versus other miners and versus the market.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com​​​​​​​

Highlights The Biden Administration's $2.25 trillion infrastructure plan rolled out yesterday will, at the margin, boost global demand for energy and base metals more than expected later this year and next.  Global GDP growth estimates – and the boost supplied by US stimulus – once again will have to be adjusted higher (Chart of the Week). Energy and metals fundamentals continue to tighten. OPEC 2.0's so-far-successful production management strategy will keep the level of supply just below demand, which will keep Brent crude oil on either side of $60/bbl. Base-metals output will struggle to meet higher demand from the ongoing buildout of renewables infrastructure and growing electric-vehicle sales. Of late, concerns that speculative positioning suggests prices will head lower – or, at other times, higher – are entirely misplaced: Spec positioning conveys no information on price levels or direction.  Energy and metals prices, on the other hand, do convey useful information on spec positioning, demonstrating specs do not lead the news or prices, they follow them. Short-term headwinds caused by halting recoveries and renewed lockdowns – particularly in the EU – will fade in 2H21 as vaccines roll out, if the experience of the UK and US are any guide.  Continued USD strength, however, would remain a headwind. Feature If the Biden administration is successful in getting its $2.25 trillion infrastructure-spending bill through Congress, the US will join the rest of the world in the race to re-build – in some cases, build anew – its long-neglected bridges, roads, schools, communications and high-speed transportation networks, and, critically, its electric-power grid.  There's a lot of game left to play on this, but our Geopolitical Strategy group is giving this bill an 80% of passage later this year, after all the wrangling and log-rolling in Congress is done. In and of itself, the infrastructure-directed spending coming out of Biden's plan will be a catalyst for higher US industrial commodity demand – energy, metals and bulks.  In addition, it will support the lift in the demand boost coming out of higher GDP growth globally, which will be pushed higher by US fiscal spending, as the Chart of the Week shows.  Of note is the extremely robust growth expected in India, China and the US, which are among the largest consumers of industrial commodities globally.  Overall growth in the G20 and globally will be expansive in 2022 as well. Chart of the WeekBiden's $2.25 Trillion Infrastructure Bill Will Boost Global Commodity Demand Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Higher GDP growth translates directly into higher demand for commodities, all else equal, as can be seen in the relationship between EM and DM GDP, supply and inventories and Brent crude oil prices in Chart 2.  While we have reduced our Brent forecast for this year to $60/bbl on the back of renewed demand-side weakness in the EU due to problems in acquiring and distributing COVID-19 vaccines, we expect this to be reversed next year and into 2025, with prices trading between $60-$80/bbl (Chart 3).  OPEC 2.0, the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, has done an excellent job of keeping the level of oil supply below demand over the course of the pandemic, which we expect to continue to the end of 2025.1 Chart 2Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Chart 3Brent Crude Oil Prices Will Average - / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 As the Biden plan makes its way through Congress, markets will get a better idea of how much diesel fuel, copper, steel, iron ore, etc., will be required in the US alone.  What is important to note here that the US is just moving to the starting line, whereas other economies like China and the EU already have begun their investment cycles in renewables and EVs.  At present, key markets already are tight, particularly copper (Chart 4) and aluminum (Chart 5).  In both markets, we expect physical deficits this year and next, which inclines us to believe the metals leg of this renewables buildout is just beginning – higher prices will be required to incentivize the development of new supply.2  Chart 4Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Chart 5...As Will Aluminum ...As Will Aluminum ...As Will Aluminum This is particularly important in copper, where growth in mining output of ore has been flat for the past two years.  Copper is the one metal that spans all renewables technologies, and is a bellwether commodity for global growth.  We expect copper to trade to $4.50/lb (up ~ $0.50/lb vs spot) on the COMEX in 4Q21 on the back of increasing demand and tight supplies – i.e., falling mining supply and refined copper output growth (Chart 6). Worth noting also is steel rebar and hot-rolled coil prices traded at record highs this week on Chinese futures markets.  Stronger steel markets continue to support iron ore prices, although the latter is trading off its recent highs and likely will move lower toward the end of the year as Brazilian supply returns to the market.3  We use steel prices as a leading indicator for copper prices – steel leads copper prices by ~ 9 months.  This makes sense when one considers steel is consumed early in infrastructure and construction projects, while copper consumption occurs later as airports and houses are fitted with copper for electric, plumbing and communications applications. Chart 6Copper Ore Output Flat Copper Ore Output Flat Copper Ore Output Flat   Does Speculative Positioning Matter? Of late, media pundits and analysts have cited an unwinding of speculative positions in oil and metals markets following sharp run-ups in net long positions as a harbinger of weaker prices in the near future (Chart 7).4  At other times, speculation has been invoked as a reason for price surges – e.g., when oil rocketed  toward $150/bbl in mid-2008, which was followed by a price collapse at the start of the Global Financial Crisis (GFC).5 Brunetti et al note, "The role of speculators in financial markets has been the source of considerable interest and controversy in recent years. Concern about speculative trading also finds support in theory where noise traders, speculative bubbles, and herding can drive prices away from fundamental values and destabilize markets." (p. 1545) Chart 7Speculative Positioning Lower In Brent Than WTI Speculatives Positioning Lower in Brent Than WTI Speculatives Positioning Lower in Brent Than WTI We recently re-tested earlier findings in our research, which found that knowledge of how specs are positioned – either on the long or the short side of the market – conveys no information on the level of prices or the change that should be expected given that knowledge.  However, knowledge of the price level does convey useful information on how speculators are positioned in futures markets.6 In cointegrating regressions of speculative positions in crude oil, natural gas and copper futures on price levels for these commodities, we find the level of prices to be a statistically significant determinant of spec positions. We find no such relationship using spec positions as an explanatory variable for prices.7 On the other hand, Chart 2 above is an example of statistically significant relationships for Brent and WTI price as a function of supply-demand fundamentals displaying coefficients of determination (r-squares) of close to 90% in the post-GFC period (2010 to now).  This supports our earlier findings regarding spec behavior: They follow prices, they don't lead them.8 We are not dismissive of speculation.  It plays a critical role in markets, by providing the liquidity that enables commodity producers and consumers to hedge their price exposures, and to investors seeking to diversify their portfolios with commodity exposures that are uncorrelated to their equity and bond holdings.  Short-Term Headwinds Likely Dissipate COVID-19 remains the largest risk to markets generally, commodities in particular.  The mishandling of vaccine rollouts in the EU has pushed back our assumption for demand recovery deeper into 2H21, but it has not derailed it.  We expect COVID-related deaths and hospitalizations to fall in the EU as they have in the UK and the US following the widespread distribution of vaccines, which should occur in the near future as Brussels organizes its pandemic response (Chart 8).  Making vaccines available for other states in dire straits will follow, which will allow the global re-opening to progress as lockdowns are lifted (Chart 9). Chart 8EU Vaccination Rollouts Will Boost Global Economic Recovery Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Chart 9Global Re-Opening Has Slowed, But Will Resume In 2H21 Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals The other big risk we see to commodities is persistent USD strength (Chart 10).  The dollar has rallied for the better part of 2021, largely on the back of improving US economic prospects relative to other states, and success in its vaccination efforts.  The resumption of the USD's bear market may have to wait until the rest of the world catches up with America's public-health response to the pandemic, and the global economy ex-US and -China enters a stronger expansionary mode. Bottom Line: We remain bullish industrial commodities expecting demand to improve as the EU rolls out vaccines and begins to make progress in arresting the pandemic and removing lockdowns.  Global fiscal and monetary policy, which likely will be bolstered by a massive round of US infrastructure spending beginning in 4Q21 will catalyze demand growth for oil and base metals.  This will prompt another round of GDP revisions to the upside.  The dollar remains a headwind for now, but we expect it to return to a bear market in 2H21. Chart 10The USD's Evolution Remains Important The USD's Evolution Remains Important The USD's Evolution Remains Important   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 Going into the April 1 meeting of OPEC 2.0 today, we are not expecting any increase in production.  OPEC earlier this week noted demand had softened, mostly due to the slow recovery from the COVID-19 pandemic in the EU, which, based on their previous policy decisions, suggests the producer coalition will not be increasing production.  The coalition led by KSA and Russia will have to address Iran's return as a major exporter to China this year, which appears to have been importing ~ 1mm b/d of Iranian crude this month (Chart 11).  This puts Iran in direct competition with KSA as a major exporter to China, in defiance of the US re-imposition of sanctions against Iranian exports.  China and Iran over the weekend signed a 25-year trade pact that also could include military provisions, which could, over time, alter the balance of power in the Persian Gulf if Chinese military assets – naval and land warfare – deploy to Iran under their agreement.  Details of the deal are sparse, as The Guardian noted in its recent coverage.  Among other things, government officials in Tehran have come under withering criticism for entering the deal, which they contend was signed with a "politically bankrupt regime."  The Guardian also noted US President Joe Biden " is prepared to make a new offer to Iran this week whereby he will lift some sanctions in return for Iran taking specific limited steps to come back into compliance with the nuclear agreement, including reducing the level to which it enriches uranium," in the wake of the signing of this deal. Base Metals: Bullish Copper fell this week, initially on an inventory build, and has now settled right under the $4/lb mark, as investors await details on the US infrastructure bill unveiled in Pittsburgh, PA, on Wednesday.  According to mining.com, a major chunk of the proposed bill will be devoted to investments in infrastructure, which will be metals-intensive.  Precious Metals: Bullish Gold fell further this week, as US treasury yields rose, buoyed by the increased US vaccine efforts and President Biden’s proposed spending plans (Chart 12). USD strength also worked against the yellow metal, which has been steadily declining since the beginning of this year.  COMEX gold fell below the $1,700/oz mark for the third time this month and settled at $1,683.90/oz on Tuesday. Chart 11 Sporadic Producers Will Be Accomodated Sporadic Producers Will Be Accomodated Chart 12 Gold Trading Lower On The Back of A Strong Dollar Gold Trading Lower On The Back of A Strong Dollar     Footnotes 1     Please see Five-Year Brent Forecast Update: Expect Price Range of $60 - $80/bbl, which we published 25 March 2021.  It is available at ces.bcaresearch.com. 2     Please see Industrial Commodities Super-Cycle Or Bull Market?, which we published 4 March 2021 for additional discussion, particularly regarding the need for additional capex in energy and metals markets. 3    Please see UPDATE 1-Strong industrial activity, profit lift China steel futures, published by reuters.com 29 March 2021. 4    See, e.g., Column: Frothy oil market deflates as virus fears return published 23 March 2021. 5    Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), " Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74, for further discussion. 6    Please see Specs Back Up The Truck For Oil, which we published 26 April 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility published 10 May 2018.  Both are available at ces.bcaresearch.com. 7     We group money managers (registered commodity trading advisors, commodity pool operators and unregistered funds) and swap dealers (banks and trading companies providing liquidity to hedgers and speculators) together to test these relationships. 8    In our earlier research, we also noted our results generally were supported in the academic literature.  See, e.g., Fattouh, Bassam, Lutz Kilian and Lavan Mahadeva (2012), "The Role of Speculation in Oil Markets: What Have We Learned So Far?" published by The Oxford Institute For Energy Studies.   Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights President Biden’s $2.4 trillion “American Jobs Plan” is a major US public investment that will dispel any endogenous deflationary tail risk from the US economy this cycle, increase inflation expectations yet boost productivity, and hike corporate taxes. The proposal has an 80% chance of passage before the end of the year given that infrastructure is popular and Democrats can pass the bill via reconciliation with zero Republican votes.   The $2.4 trillion infrastructure proposal will take effect over eight years and will be offset by corporate tax hikes that will take effect over 15 years. The increase in the budget deficit will be around $400 billion if all tax hikes pass and $1.4 trillion if only half the tax hikes pass. The American Families Plan will follow with another roughly $700 billion to $1.3 trillion increase to the budget deficit, depending on how much individual/household taxes go up. But this bill only has a 50/50 chance of passing before the 2022 midterm elections. Investors should maintain a bullish cyclical (12-month) bias and keep favoring value stocks, industrials, and materials over tech and health care. We also recommend going long consumer discretionary stocks and energy large caps versus small caps. Feature President Joe Biden spoke in Pittsburgh on Wednesday to unveil his economic vision and policy proposals going forward. Biden proposed a $2.4 trillion “American Jobs Plan” infrastructure and green energy package to be implemented over eight years, which will be part of a $4 trillion-plus “Build Back Better” legislative agenda that will be partially offset by an estimated $3 trillion in tax hikes to take effect over 15 years. The result will be a pro-cyclical boost to fiscal thrust, GDP growth, and inflation expectations; some potential for a productivity boom; a possible expansion of the social safety net; and tax reform that reduces US corporate profits. Pennsylvania is a Rust Belt state, Biden’s home state, and a critical swing state in the 2016 and 2020 elections, so the location makes sense. Biden aims to solidify the economic recovery and restore the Democratic Party’s leadership on infrastructure and manufacturing after Republican President Trump nearly stole their thunder. If he succeeds then his administration and party will improve their support substantially. The US economy is opening rapidly while the COVID-19 vaccination campaign continues apace. Chart 1 shows that household disposable income and net worth surged as a result of giant fiscal relief while consumer spending lags behind due to social distancing. The $1.7 trillion treasure chest of personal savings creates the basis for an increase in spending as consumers get vaccinated and regain their freedom. Economic policy uncertainty has collapsed, even relative to global uncertainty (Chart 2). There are no longer doubts about whether government will spend the country out of a slump. Even state and local governments have been bailed out despite having much stronger finances than predicted. However, there are doubts about how much more deficit spending the Biden administration will be able to push through, and that is what will now be debated in Congress following Biden’s Pittsburgh proposals. Chart 1Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Chart 2US Policy Uncertainty Soon To Revive US Policy Uncertainty Soon To Revive US Policy Uncertainty Soon To Revive There will not be much of a deflationary tail risk to the new business cycle in the context of this expansive fiscal policy, as bullish investors are well aware. However, policy uncertainty will revive going forward as more spending will raise the risk of economic overheating, tax hikes will affect different sectors disproportionately, deficits and debt will balloon, and Biden’s challenges with immigration and foreign policy will intensify. There is an upside risk for the stock market that Congress delays tax hikes but this is not our base case. In this week’s report we revise and update our estimates for the impact of Biden administration’s legislative proposals – including his projected $4 trillion-plus in spending on infrastructure, health, and education – taking into consideration Biden’s Pittsburgh speech, his first press conference on March 25, and all the rumors and leaks that have come to light over the past two weeks. Back-Of-The-Envelope Estimates Of US Growth And Output Gap After ARPA First we need to revise our back-of-the-envelope estimates of the impact of the $1.9 trillion American Rescue Plan Act (ARPA). Chart 3 shows two scenarios for US GDP growth. The first is the “maximum” scenario, in which US real GDP grows by 10.7% because all of the money authorized under the new law is spent. The second scenario puts real growth at 6% by using only the Congressional Budget Office’s expected federal outlays (as opposed to budget authority) to estimate the government spending component of GDP. In both cases we assume that 33% of the fiscal relief is spent in FY2021 and the remainder in FY2022. These scenarios do not include Biden’s American Jobs and Families Plans because those bills have yet to be drafted, let alone pass Congress. Chart 3Revised US GDP Estimates With ARPA Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Consensus estimates put real GDP growth at 5.7% and the Federal Reserve estimates that 2021 growth will clock in at 6.5%, as shown in Chart 4. Not all of the government spending will translate directly into aggregate demand because 37% of the ARPA consists of direct checks and unemployment benefits to households that may only spend one-third of the amount they receive (while paying down debt with a third of it and saving a third of it). Yet more government deficit spending is coming down the pike and consumers are sitting on a huge pile of savings, which implies that growth could surprise to the upside of consensus estimates. Chart 4Consensus Estimates Of US GDP PosT-ARPA Consensus Estimates Of US GDP PosT-ARPA Consensus Estimates Of US GDP PosT-ARPA Chart 5 uses our same back-of-the-envelope calculation to estimate the impact of current law (including ARPA) on the US output gap. The output gap is the difference between actual GDP growth and potential GDP growth – during busts the country’s growth falls well beneath potential while during booms it rises above potential. The chart shows that if all of the government relief funds are spent then the output gap will be more than closed by the end of the year. By contrast, the CBO’s January projection shows the output gap persisting through 2025. While our estimates in Chart 5 may be too generous regarding federal cash handouts translating directly to consumer spending and higher demand, nevertheless the consensus estimate is entirely understated and out of date as a result of ARPA and the Biden administration’s additional fiscal spending that is coming. Chart 5Revised US Output Gap Estimates With ARPA Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Chart 6Revised US Budget Deficit Projection Post-ARPA Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Chart 6 updates our US budget deficit outlook using the CBO’s February budget baseline. The ARPA’s increase in government spending is added to create the new Democratic Party status quo scenario over the next ten years, with the budget normalizing by 2025. The Democratic low spending scenario assumes that Biden passes the $2.4tn infrastructure-plus plan announced in Pittsburgh (Table 1) using all the revenue from all the corporate tax hikes. Biden’s agenda will be broken into separate bills with varying probabilities of success. So in our budget deficit outlook we only include the infrastructure-and-corporate-tax-hikes component that is apparently being prioritized. Table 1Biden's 'American Jobs Plan' Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Bottom Line: US growth will surprise to the upside of consensus estimates while the US output gap will be closed much sooner than expected. Financial markets are largely prepared for this outcome, although it reinforces that investors should maintain a cyclically bullish view and tactically should buy on the dips. Biden’s Pittsburgh Speech And ‘American Jobs Plan’ Budget Impacts Our view is that the Biden administration has a subjective 80% chance of passing a second major budget reconciliation bill (FY2022) and a 50% chance of passing a third budget reconciliation bill (FY2023). The question appears to be resolved that Democrats will prioritize infrastructure over social welfare. Whichever one they prioritize can be linked to tax hikes and yet will still be highly likely to pass given that no Republican votes are needed under budget reconciliation rules. Moderate Democrats may water down the tax provisions but they would be suicidal to oppose their entire party on the administration’s signature piece of legislation. The social spending bill, assuming it follows infrastructure, would have to be pursued via a third reconciliation bill for FY2023 but it is less likely to pass. By next year Biden will have spent a lot of his political capital, fiscal spending fatigue will be a real phenomenon, and the 2022 midterm elections will loom. What matters for investors is the impact on the budget deficit since that will determine how big of an impact will hit GDP and how long US fiscal policy remains accommodative. Table 2 shows the impact on the budget balance if Biden gets all of his spending and all revenue proposals (Baseline), if he gets all the spending but only half the tax hikes (Scenario 1), and if he gets half the spending and half the tax hikes (Scenario 2). Scenarios 3 and 4 treat the social spending plan with varying degrees of tax revenue from the proposed individual tax hikes, while Scenarios 5 and 6 treat the infrastructure plan with varying tax revenue from corporate tax hikes. Table 2Biden’s Forthcoming ‘American Jobs Plan’ Legislative Proposals Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Table 3 shows the Biden campaign’s proposed tax hikes by line item along with the spending proposals. The range of net deficit spending runs from about $400 billion to about $3 trillion over ten years, which is a broad range and not very telling but which seems, subjectively, likely to settle in the $2 trillion range. Chart 7 shows the budget deficit’s deviation from the status quo trajectory in each of these scenarios, i.e. additional fiscal thrust. Table 3Biden’s Tax-And-Spend Proposals In Detail Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Chart 7US Budget Deficit Projections With ‘American Jobs Plan’ Agenda Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda The infrastructure package consists of a range of proposals having to do with traditional roads and bridges, renewable energy, rural broadband Internet, domestic manufacturing incentives, supply chain security initiatives, affordable housing, and research and development (see Table 1 above). The social safety net expansion consists of making permanent the child tax credit that was extended in the ARPA; lowering the Medicare eligibility requirement to age 60 from 65; lengthening paid family/medical leave for workers; funding universal pre-school; and funding tuition-free community college. Some Democrats will oppose delaying social spending and tax hikes because they may not pass before the midterms and Republicans could easily take back control of the House of Representatives in 2022. Hence there is still a chance that Biden will pursue infrastructure on a bipartisan and piecemeal basis while using the FY2022 budget reconciliation for his social spending and tax hikes. The reasoning goes as follows: Historically the House has a high probability of shifting against a new president’s party in his first midterm election. The only exception to this rule were George W. Bush and Franklin D. Roosevelt. Republicans will definitely oppose social welfare and tax hikes, whereas they could be convinced to support an infrastructure plan. Republicans will not vote for infrastructure if it includes tax hikes and many Democrats believe that long-term infrastructure spending will enhance productivity and hence need not require revenue offsets. Hence there is still a chance of a bipartisan infrastructure bill. This would jeopardize its overall passage but it would ensure that Democrats could pass their social agenda via FY2022 reconciliation. What are the odds of bipartisanship? Throughout this year we have reserved some space for bipartisan lawmaking to take place under the radar. A recent example is the Paycheck Protection Program (PPP) Extension Act of 2021, which Biden signed into law on March 30. This is a bipartisan extension of the small business emergency loan program that began under President Trump. Senate Majority Leader Mitch McConnell quashed objections from within his party to extending the program, which has substantial support from the National Federation of Independent Business.1 The result was a 92-7 vote majority in the Senate, showing that Republican cooperation is possible. The fact that Republicans also cleared the way for the use of earmarks, or pork barrel spending directed at a critical lawmaker’s constituency in exchange for his or her vote, also suggests that bipartisanship is possible, particularly on infrastructure. Republicans can also be brought to support efforts to secure supply chains and energize the US technological race with China, such as the $50 billion funding for semiconductor manufacturing, which could be part of a major infrastructure package or regular budget appropriations. The catch is that Republicans will not support tax hikes, unionization, IRS strengthening, workplace enforcement, or climate change policies pursued under the guise of infrastructure. As a result the Democrats are highly incentivized to bypass Republicans from the beginning and pursue their agenda through two separate reconciliation bills. Finally, Democrats still have the option of removing the Senate filibuster, enabling regular bills to pass with merely 51 votes. Investors should plan on this occurring despite the news media narrative suggesting that moderate Democrats do not want it to happen – the point is that it is not an invincible check on the ruling party’s power. Biden signaled in his first press conference on March 25 that he is willing to see the filibuster removed. Bottom Line: Democrats can pass most of their infrastructure and social safety net proposals via budget reconciliation bills for FY2022 and FY2023, without a single Republican vote. If they do so they can only spare three votes in the House and zero votes in the Senate – meaning that the devil is in the details. Their odds of passing the first are high at a subjective 80% but then their odds of passing the second are 50/50 at best. Thus it is not wise to bet against Democratic tax hikes or new spending. The net impact on the deficit will be negative and hence stimulating for the economy. Growth and inflation will surprise to the upside. Biden’s Political Capital Still Moderate-To-Strong Our argument above is based in great part on Biden’s political capital, which is moderate but likely to strengthen as consumer sentiment rises. Table 4 updates our US Political Capital Index. Political polarization is subsiding from extreme peaks, and business sentiment and economic conditions are improving (with a surge in capex intentions albeit rising concerns over regulation). Table 4Biden’s Political Capital Sufficient For Another Major Bill Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda The weak spot is household sentiment as Biden’s approval rating is falling (normal for presidents as their honeymoon ends). However, consumer confidence is already picking up and will surely accelerate with vaccinations gaining ground, the dole being delivered, and the service sector reviving. Chart 8 shows that Biden’s approval rating is settling in the mid-50% range, which is substantially better than Trump’s at this time although worse than President Obama’s. Biden can be understood as a synthesis of these two predecessors given that he is coopting Trump’s agenda on fiscal spending, infrastructure, trade, and manufacturing while continuing Obama’s legacy on regulation, immigration, civil rights, and foreign policy. We expect Biden’s approval rating not to fall too far, unless he suffers a foreign policy disaster with China, Iran, or Russia, given that over 50% of voters will tend to support him as long as President Trump is the obvious alternative. Chart 9 suggests that Biden’s economic approval rating is weak but this score is going to rise once the new relief funds are distributed and the economic recovery gets going full steam. The early business cycle will probably be a constant source of support for the president over his four-year term. Chart 8Biden’s Approval Rating Fairly Stout Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Chart 9Biden’s Approval On Economy Will Rise Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Remarkably even the US Congress is gaining greater popular approval (Chart 10). This is very rare in modern times and could suggest that a major change is taking shape as Congress pursues populist fiscal policy under both Trump and Biden. Congress is handing out free money so people suddenly don’t hate it as much. There is a limit to how popular Congress will become and it will certainly not shake off its hard-earned reputation for gridlock and partisan rancor by suddenly exemplifying enlightenment and bipartisanship. But any rise in congressional approval is notable and would imply greater political capital for the current government and hence greater policy certainty for investors in the short run. Biden’s political capital is not yet suffering due to economic overheating as the latter has not yet happened – but it is a risk to monitor over the medium term. Inflationary pressures continue to build across the supply chain. Small businesses are increasingly flagging cost of labor as a rising concern while consumer price inflation is likely to pick up. Chart 10Congress Is Becoming More Popular Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Inflation expectations are critical and will take time to change. Americans think about inflation through prices at the pump. Chart 11 shows the US and global crude oil price and average gasoline prices at the gas station for US consumers. Gasoline prices have surged although they are not yet at the $4 per gallon level that causes popular concern to escalate sharply. Chart 11Inflation Is Coming But Geopolitics Brings Oil Price Volatility Inflation Is Coming But Geopolitics Brings Oil Price Volatility Inflation Is Coming But Geopolitics Brings Oil Price Volatility Oil prices are expected to go higher in the coming two years, according to our Commodity & Energy Strategy, but over a five-year period global supply-demand trends and balances suggest that the price will fluctuate within the $60-$80 dollar range. Biden’s regulations and foreign policy will introduce some volatility by hampering domestic US production, triggering sparks in the Middle East over Iran, and yet ultimately increasing global supply via any diplomatic deal with Iran. The BCA Research House View holds that today’s inflation is a temporary phenomenon whereas a more substantial bout of inflation is waiting in the medium-to-long term. The reason our strategists are not overly concerned in the near term is that there is still substantial slack in the economy: the labor force participation rate has fallen from 63.3% to 61.4% since the pandemic, the U6 unemployment rate stands at 11.1% (up from 7% prior to the pandemic), and the all-important employment-to-population ratio for prime-age workers stands at 57.6%, down from 61.1% prior to the pandemic. However, this slack is on pace to be tightened quickly as long as the pandemic subsides and Biden’s American Jobs Plan passes. Bottom Line: Our US Political Capital Index suggests Biden’s political capital is moderate-to-strong, which supports our view that he can pass at least one more major piece of legislation and possibly two. Inflation expectations will rise further and the selloff in US treasuries will continue. Investment Takeaways The market rally since January has priced a lot of the good news from Biden’s proposals, which are broadly similar to his campaign proposals. There is not a clear legislative strategy and passing two major bills before the midterm elections is a stretch. The priority bill, however, looks to pass by the end of this year after a roller-coaster ride of congressional negotiations and horse-trading. Deep cyclical sectors will benefit the most. We remain long value over growth stocks, specifically industrials and materials. We are also maintaining our long BCA infrastructure basket at least until passage of the bill is secured. Our infrastructure basket consists of a range of materials and machinery producers, construction services, and environmental services, and does not focus on headline “infrastructure” companies in the utilities and telecoms sectors. We recommend going long large cap energy stocks relative to small caps, which will have a harder time adjusting to Biden’s regulatory, tax, and green agenda. A long-term infrastructure plan that includes green energy, manufacturing, digital infrastructure, and R&D could create a productivity boost. Hiking the corporate tax rate to 28% is negative for corporate earnings but it will take place over a longer time frame and is being introduced in the context of a cyclical upswing. Hence we remain bullish over the course of this year. Biden’s Pittsburgh speech ostensibly confirmed the news flow over the past month suggesting that the Democrats will not propose a government-provided health insurance option in their upcoming legislative proposals. Instead they are prioritizing lowering the Medicare eligibility requirement and enabling Medicare to negotiate pharmaceutical prices. Our short of the managed health care sub-sector suffered from this shift in policy focus although we will maintain the trade as we expect the public option to reemerge at a later date. Meanwhile our pair trade of long health equipment and facilities relative to pharmaceuticals and bio-tech continues to perform well (Chart 12). A clear beneficiary of the US’s newfound proactive fiscal policy is the consumer. Consumer spending has not fully recovered from the pandemic and recession. Household disposable income ticked down in February from January, after the distribution of the government’s $900 billion COVID-19 relief funds in the Consolidated Appropriations Act passed in December. However, disposable income is up 8% over the 12 months since COVID broke out, due to fiscal relief. The result of lower spending and higher income is an increase in the personal saving rate to 13.6% in February, well above normal, as our US Bond Strategy highlights in its latest report. Recent research from our US Investment Strategy highlights that consumer growth should track relatively well with increases in household net worth, implying that nominal personal consumption expenditures could grow at a rate of 8.8% by the end of the year and 6.9% by the end of next year. Chart 12Stay Long Industrials Over Health Care Stay Long Industrials Over Health Care Stay Long Industrials Over Health Care Chart 13Go Long Consumer Discretionary Stocks Go Long Consumer Discretionary Stocks Go Long Consumer Discretionary Stocks In this context we take a positive view of consumer stocks in general. Cyclically we would favor consumer discretionary stocks and recommend investors go long. While discretionary spending should outperform as the economic upswing gains pace, we are holding consumer staples as a hedge against bad news (Chart 13). Not only will Biden’s tax hikes, inflation, and the rise in bond yields cause ongoing risks to cyclical sectors, but Biden also faces a series of imminent foreign policy tests with China/Taiwan, Iran, Russia, and North Korea, as highlighted in our sister Geopolitical Strategy.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1Political Risk Matrix Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Table A2APolitical Capital: White House And Congress Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Table A2BPolitical Capital: Household And Business Sentiment Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Table A2CPolitical Capital: The Economy And Markets Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda Table A3Biden’s Cabinet Position Appointments Biden’s Pittsburgh Speech And Legislative Agenda Biden’s Pittsburgh Speech And Legislative Agenda   Footnotes 1     Bill Scher, “The Bipartisan Senate Bill You Haven’t Heard About,” Real Clear Politics, realclearpolitics.com.