Commodities & Energy Sector

Feature The global macro landscape over the next six months or so will be characterized by a booming US economy and decelerating growth in China. Financial markets will move accordingly. US Treasury yields will remain under upward pressure, the US dollar will rebound, commodities prices will experience a setback and EM equities will continue underperforming DM stocks. The upcoming US economic boom is a well-known narrative and does not require much elaboration. China’s slowdown, on the other hand, is a matter of debate among investors and commentators. We have been arguing that macro policy tightening and a resumption of regulatory clampdowns on the financial system and property market are bound to result in a growth deceleration in China. There are already leading indicators that point to an impending growth slowdown: Chart 1China Is Set To Decelerate China Is Set To Decelerate China Is Set To Decelerate The latest datapoint for domestic orders from the PBOC’s survey of 5000 industrial enterprises has relapsed in Q1. It leads A-share companies EPS growth by six months (Chart 1, top panel). The message is that industrial companies’ profit growth will once again slow in H2 2021. The recent setback in Chinese A-shares is evidence that markets are already beginning to price in a profit deceleration in H2. The bottom panel of Chart 1 indicates that banks’ claims on enterprises and households have rolled over and will continue downshifting. This is consistent with easing bank loan approvals and reflects policymakers’ guidance for banks. In Charts 3, 4, 6, 7, 8, 9, 10, 11 and 13 below, we illustrate more indicators and evidence of a forthcoming peak in the Chinese business cycle in general and commodities prices in particular. Weakening growth in China will hurt EM stocks and currencies more than those in DM, as many emerging economies are exposed to industrial commodities that are much more sensitive to demand in China versus trends in the US. Also, many Asian economies export more to China than they do to the US and Europe. Besides, the growth outlook in EM (ex-China, Korea and Taiwan) remains sub-par, especially relative to the US and DM more broadly. The reasons for this are slower vaccination rates and by extension economic reopening, a lack of fiscal stimulus and unhealthy banking systems. Notably, Chart 39 below demonstrates that EM bank stocks are breaking down relative to DM bank stocks. This potential breakdown reflects the state of EM fundamentals relative to those of DM. This week we recommend a new trade: short EM banks / long DM banks. In the US, the feature story will be the brisk pace of its reopening, an economic boom and intensifying inflationary pressures. So long as US bond yields continue rising, the US dollar will be supported. The next downleg in the greenback will occur when inflation rises but the Fed explicitly refuses to tackle it. Odds are that we are several months away from that. Hence, rising US bond yields will prop up the US dollar for now. The rebound in the US dollar and rising US bond yields will weigh on EM fixed income. The bottom panel of Chart 30 below illustrates that EM credit spreads negatively correlate with commodity prices. All in all, EM credit spreads will likely widen. Together with ascending US Treasury yields, this means higher EM sovereign and corporate dollar bond yields. The latter have always been associated with lower EM share prices (Chart 2, top panel). Chart 2Rising Corporate Bond Yields Are A Threat To Stocks Rising Corporate Bond Yields Are A Threat To Stocks Rising Corporate Bond Yields Are A Threat To Stocks Strategy: As a tactical strategy (three to six months), last week we recommended downgrading the allocation to EM within global equity and credit portfolios from neutral to underweight. We also recommended shorting a basket of the following EM currencies versus the US dollar for the next several months: HUF, PLN, PHP, TRY, CLP, ZAR, KRW, BRL and THB. Strategic portfolios should maintain neutral allocations to EM equities, credit, local bonds and currencies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Chinese Share Prices Point To A Top In Commodities Prices The recent underperformance of Chinese onshore cyclical stocks relative to defensive stocks heralds a slowdown in growth and has historically been a good indicator for raw materials prices. Consistently, the latest pullback in share prices of materials companies included in the MSCI China Investable Index also signals a drop in industrial metals prices. Chart 3Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Chart 4Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Chinese Share Prices Point To A Top In Commodities Prices Commodities: New Secular Bull Market Or A Trading Range? Various Chinese liquidity and money measures have historically led the CRB Raw Materials Price Index and presently signal a relapse in commodities. The 200-year chart showing raw materials (excluding oil and gold) prices in real (inflation-adjusted) terms suggests that commodities prices have not undershot their long-term time-trend (Chart 5). We do not argue for a continuation of a structural bear market in commodities, but a medium-term setback is likely in the next three to six months. Chart 5Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Chart 6Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Chart 7Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? Commodities: New Secular Bull Market Or A Trading Range? EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 The rally in EM share prices last year has priced the ongoing profit recovery. However, the apex in Chinese money/credit measures entails an EM profit slowdown in H2 this year (Chart 8). Besides, the considerable pullback in Chinese cyclicals-to-defensive stock prices implies further drawdown in EM share prices. Chart 8EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 Chart 9EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 EM Share Prices Are Beginning To Price A Profit Slowdown In H2 2021 The Chinese Economy: Shifting Into Low Gear In China, liquidity and money measures portend a peak business cycle. Excluding TMT companies, Chinese investable stocks have failed to break above their trading range of the past ten years. Notably, the slowdown is not limited to the old economy. The Caixin New Economy Index has dropped to its early 2019 level. Chart 10The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Chart 11The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Chart 12The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Chart 13The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear The Chinese Economy: Shifting Into Low Gear Peak Growth And Equity Sentiment We have been showing Chart 14 for the past several months. The record high sentiment on EM equities in January preceded with an apex in EM share prices in February. This measure of sentiment is not yet low enough to expect a bottom in EM stocks. Chart 15 shows a similar indicator for euro area equities. Will it play out in the euro area as it did with EM? Chart 14Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Chart 15Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Peak Growth And Equity Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment The numbers of IPOs and secondary issuances have risen to a record high in China and EM. Often, this development is consistent with peak investor sentiment that coincides with some sort of top in share prices. Chart 16Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Chart 17Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Chart 18Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Booming IPOs And Secondary Issues = Peak Investor Sentiment Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity earnings yield minus interest rates (a proxy for equity risk premium) in EM is similar to that of the US. Hence, adjusted for local interest rates, EM stocks are not cheap. In fact, European and Japanese stocks are cheaper than EM stocks. Chart 19Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Chart 20Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities Equity Risk Premium: EM Equities Are Not Cheaper Than European And Japanese Equities A US Dollar Rebound = EM Setback Both EM equity recent selloffs and relative underperformance versus DM occur alongside US dollar strength. Besides, EM equity relative performance often moves counter to US stocks relative performance against the global benchmark (Chart 23). Finally, emerging Asian stocks’ relative performance versus the global index has hit a major technical resistance. The path of least resistance is, for now, on the downside. Chart 21A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback Chart 22A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback Chart 23A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback Chart 24A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback A US Dollar Rebound = EM Setback EM Stocks Have Formed A Medium-Term Top The EM overall equity benchmark (shown in Chart 20) as well as EM ex-TMT stocks, EM (ex-China, Korea and Taiwan) share prices, EM small caps and the EM equal-weighted index have so far failed to break out.  The forthcoming slowdown in China, rising US Treasury yields, the US dollar rebound and poor fundamentals in EM (ex-China, Korea and Taiwan) are consistent with these technical patterns and warrant caution for now. Chart 25EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Chart 26EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Chart 27EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Chart 28EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top EM Stocks Have Formed A Medium-Term Top Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income Investor sentiment on US Treasurys is neutral, as is JP Morgan’s duration survey. Major market moves do not halt when sentiment is neutral but rather persist until sentiment becomes extreme. This and the economic boom and rising inflationary pressures in the US are the basis for higher US bond yields. The latter will push up both EM local currency and US dollar bond yields. In turn, a relapse in commodities prices will lead to a widening EM credit spread. Chart 29Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income Rising US Treasury Yields Are A Bad Omen For EM Fixed-Income The US Dollar Rebound Is In The Making The US dollar will continue its rebound as the US economic growth outpaces others and US yields rise relative to their peers. In turn, a rollover in commodities prices is a harbinger of EM currency weakness. Chart 30The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making Chart 31The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making Chart 32The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making Chart 33The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making The US Dollar Rebound Is In The Making A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World US import prices are rising in US dollar terms but not enough to offset exporters’ currency appreciation of the past 12 months. In fact, export prices in local currency terms have been tame in China and Korea. The greenback might appreciate in the near term to redistribute inflationary pressures from the US to the rest of the world, where the risk remains deflation/disinflation. Chart 34A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World Chart 35A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World A Strong Dollar Will Redistribute Inflation From The US To The Rest Of the World EMs’ Poor Fundamentals In recent weeks, Brazil and Russia have hiked their policy rates. However, core consumer price inflation in both countries remains well behaved. Both economies are sluggish. In short, economic growth and inflation did not herald higher policy rates. Higher borrowing costs will jeopardize growth in these and other EM economies. Critically, the breakdown in EM relative to DM bank share prices (Chart 39) is a sign of poor health of EM banks and their inability to finance the economic recovery. Chart 36EMs' Poor Fundamentals EMs' Poor Fundamentals EMs' Poor Fundamentals Chart 37EMs' Poor Fundamentals EMs' Poor Fundamentals EMs' Poor Fundamentals Chart 38EMs' Poor Fundamentals EMs' Poor Fundamentals EMs' Poor Fundamentals Investment Ideas A few of our investment recommendations outside our main strategy are: (1) long Chinese A-shares / short investable stocks; (2) long global value / short Chinese investable value stocks; (3) long global industrials / short global materials; (4) short a basket of EM currencies versus the US dollar or go long EM currency volatility. This week we are adding  a new recommendation: short EM banks / long DM banks (Chart 39). Chart 39Investment Ideas Investment Ideas Investment Ideas Chart 40Investment Ideas Investment Ideas Investment Ideas Chart 41Investment Ideas Investment Ideas Investment Ideas   Footnotes Equities Recommendations Growth Divergence: Booming US, Slowing China Growth Divergence: Booming US, Slowing China Currencies, Credit And Fixed-Income Recommendations

Highlights Extremely accommodative fiscal policy and a rapid pace of vaccination puts the US on track to close its output gap by the end of the year. The situation is different in Europe, and the euro area economy will likely continue to underperform the US until at least the summer. Investors are now unusually more hawkish than the Fed, whose caution is driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. The Fed’s rate projections, coupled with the extraordinary size of the American Rescue Plan, have stoked investor concerns about a significant rise in inflation. For inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. We expect a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. We recommend that investors maintain below-benchmark portfolio duration, and overweight US speculative over investment-grade corporate bonds. The fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar over the coming 0-3 months. But over a 6-12 month time horizon, we continue to favor global ex-US vs. US stocks, and expect the dollar to be lower than it is today. A Brighter Light At The End Of The Tunnel Chart I-1Even Better Than Some Optimists Would Have Predicted Even Better Than Some Optimists Would Have Predicted Even Better Than Some Optimists Would Have Predicted Over the past 4-6 weeks, the US has continued to make incredible progress in vaccinating its population against COVID-19. Chart I-1 highlights that the pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the US will have vaccinated 90% of its population by the end of September (if it is determined that the vaccine is safe to give to children). And these calculations assume the continuation of a two-dose regime, meaning that the eventual rollout of Johnson & Johnson's Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further. The situation is clearly different in Europe. The vaccination progress in several European countries is woefully behind that of the US and the UK (Chart I-2), and per capita cases in the euro area have again risen significantly above that of the US (Chart I-3). This reality motivated last week’s news that the European Union is reportedly planning on banning exports of the AstraZeneca vaccine for a period of time, as European policymakers grow increasingly concerned about the potential economic consequences of lengthened or additional pandemic control measures over the coming few months. Chart I-2Europe Is Badly Lagging The Vaccine Race… April 2021 April 2021 There was at least some positive economic news from Europe this month, as reflected by the flash manufacturing and services PMIs (Chart I-4). The euro area manufacturing PMI surpassed that of the US this month, reflecting that the prospects for goods-producing companies in Europe remain solidly linked to the strong global manufacturing cycle. Services, on the other hand, have been the weak spot in Europe, having remained below the boom/bust line since last summer (in contrast to the US). The March services PMI highlighted that this gap is now starting to narrow, although the euro area economy will likely continue to underperform the US until at least the summer. Chart I-3...And It Is Starting To Show ...And It Is Starting To Show ...And It Is Starting To Show Chart I-4Some Closure Of The Services Gap, But Still A Ways To Go Some Closure Of The Services Gap, But Still A Ways To Go Some Closure Of The Services Gap, But Still A Ways To Go   The underperformance of the European services sector over the past nine months has been due in part to more severe pandemic control measures, but also a comparatively timid fiscal policy. The IMF’s October Fiscal Monitor highlighted that the US had provided roughly eight percentage points more of GDP in above-the-line fiscal measures versus the European Union as a whole, and that was before the US December 2020 relief bill and this month’s $1.9 trillion American Rescue Plan (ARP) act were passed. The CBO estimates that the ARP will result in about US$1 trillion in outlays in 2021, which is roughly 5% of nominal GDP. Consequently, Chart I-5 highlights that consensus expectations now suggest that the output gap will be marginally positive by the end of the year, with the Fed’s most recent forecast implying that real GDP will be more than 1% above the CBO’s estimate of potential output. Chart I-5The US Output Gap Will Likely Be Closed By The End Of This Year The US Output Gap Will Likely Be Closed By The End Of This Year The US Output Gap Will Likely Be Closed By The End Of This Year The Fed Versus The Market Despite this, the Fed held pat during this month’s FOMC meeting and did not validate market expectations of rate hikes beginning in early 2023. Chart I-6 highlights the Fed funds rate path over the coming years as implied by the OIS curve, alongside the Fed’s median projection of the Fed funds rate. This means that investors are now more hawkish than the Fed, which is the opposite of what has typically prevailed since the global financial crisis. Chart I-6The Market Is Now, Unusually, More Hawkish Than The Fed The Market Is Now, Unusually, More Hawkish Than The Fed The Market Is Now, Unusually, More Hawkish Than The Fed Fed Chair Jerome Powell implied during the March 17 press conference that some FOMC participants were unwilling to change their projections for the path of interest rates based purely on a forecast, which argues that the median dot in the Fed’s “dot plot” will shift higher in the second half of the year if participants’ growth and inflation forecasts come to fruition. But Charts I-7A and I-7B suggest that the Fed’s caution is also driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. Chart I-7AA Positive Output Gap Implies… April 2021 April 2021 Chart I-7B…An Unemployment Rate Below NAIRU April 2021 April 2021   The charts highlight the historical relationship between the output gap and the deviation of NAIRU from the unemployment rate, from 2000 and 2010. In both cases, the charts show that the unemployment rate would be below the CBO’s estimate of NAIRU at the end of this year (roughly 4.5%) given the CBO’s estimate for potential (i.e. full employment) GDP and the Fed's forecast for growth. However, the Fed is forecasting that the unemployment rate will essentially be at NAIRU, which is itself above the Fed’s longer-run unemployment rate projection of 4%. As such, the Fed does not see the unemployment rate falling to “full employment” levels this year, a precondition for the onset of rate normalization. Investors should note that the relationships shown in Charts I-7A and I-7B suggest that the unemployment rate will be closer to 3-3.5% at the end of this year if the Fed’s growth forecast is correct, which would constitute full employment based on the Fed’s 4% unemployment rate target. The difference between a 3-3.5% unemployment rate and the Fed’s estimate of 4.5% translates to a gap of roughly 1.5-2.5 million jobs at the end of this year, which underscores that the Fed expects either a significant shift in temporary to permanent unemployment or an influx of unemployed workers back into the labor force who don’t quickly find jobs once social distancing ends and pandemic restrictions are no longer required. Chart I-8The Full Employment Level Of GDP Has Not Been Significantly Revised The Full Employment Level Of GDP Has Not Been Significantly Revised The Full Employment Level Of GDP Has Not Been Significantly Revised There are three possible circumstances that would resolve this seeming contradiction. The first is that the Fed’s estimate for growth this year is simply too high, and that the output gap will be close to zero at the end of the year (i.e., more in line with consensus market expectations). The second is that the CBO is understating the level of GDP that is consistent with full employment, namely that potential GDP is higher than what they currently project. But Chart I-8 shows that the CBO’s current estimate for potential output at the end of this year is only 0.4% below what it had estimated prior to the pandemic, which is smaller than the positive gap implied by the Fed’s growth estimate for this year (roughly 1.2%). The third possibility is that the Fed is overestimating the extent to which the pandemic will cause permanent damage to the labor market. As we noted in our February report, even once social distancing is no longer required, it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). A gap of 1.5-2.5 million jobs accounts for roughly 10-15% of pre-pandemic employment in retail trade, or 4-7% of the sum of retail trade, leisure & hospitality, and other services. It is possible that permanent job losses or significantly deferred job recovery of this size will occur, but it is far from clear that it will. Were job losses / deferred jobs recovery of this magnitude to not materialize, it would suggest that the US will reach full employment earlier than the Fed is currently projecting, and would significantly increase the odds that the Fed will begin to taper its asset purchases and/or raise interest rates at some point next year – which is earlier than investors currently expect. For Now, Dangerously Above-Target Inflation Is Unlikely Fed projections of a 0% Fed funds rate for the next 2 1/2 years, coupled with the extraordinary size of the American Rescue Plan, have understandably stoked investor concerns about a significant rise in inflation. Larry Summers’ recent interview with Bloomberg was emblematic of the concern, during which he criticized the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 It is true that the Federal Reserve is explicitly aiming to generate a temporary overshoot of inflation relative to its target, the Biden administration’s fiscal plan is legitimately large, and there is a tremendous pool of excess savings that could be deployed later this year once the pandemic is essentially over. Clearly, the risks of overheating must be higher than they have been in the past. But from our perspective, out-of-control inflation over the coming 12-24 months would very likely necessitate one of two things to occur, and possibly both: US consumers decide to spend an overwhelmingly large amount of the excess savings that have been accumulated. Main street expectations for consumer prices rise sharply, prompted by a public discussion about the likelihood of a shifting inflation regime. Our view is rooted in the examination of the modern-day Phillips Curve that we presented in our January report, which considers both the impact of economic/labor market slack and inflation expectations as a driver of actual inflation. The modern-day Phillips Curve posits that expectations act as the trend for inflation, and slack in the economy determines whether actual inflation is above or below that baseline. Chart I-9 highlights that the output gap worked well prior to the global financial crisis at explaining the difference between actual and exponentially-smoothed inflation, the latter acting as a long-history proxy for expectations. Pre-GFC, the chart highlights that there have been only two exceptions to the relationship that concerned the magnitude rather than the direction of inflation. Post-GFC, the relationship deviated substantially, but in a way that implied that actual inflation was too strong during the last expansion, not too weak – particularly during the early phase of the economic recovery. This likely occurred because expectations initially stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation, but ultimately declined due to a persistently negative output gap as well as in response to the 2014 collapse in oil prices (Chart I-10). Chart I-9Pre-GFC, The Output Gap Generally Explained Inflation Surprises Pre-GFC, The Output Gap Generally Explained Inflation Surprises Pre-GFC, The Output Gap Generally Explained Inflation Surprises Chart I-10Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Thus, for inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. Chart I-11 highlights that the amount of excess savings that have accumulated as a percentage of GDP does indeed significantly exceed the magnitude of the output gap, but some of those savings have been and will be invested in financial markets (boosting valuation), some will be used to pay down debt, some will eventually be spent on international travel (boosting services imports), and some will likely be permanently held as deposits in anticipation of future tax increases. And while long-term household expectations for prices have risen since the passing of the CARES act last year, the rise has merely unwound the decline that took place following the 2014 oil price collapse (Chart I-12). Chart I-11A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent Chart I-12Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base   For now, this framework points to a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Investment Conclusions Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. While the Fed is likely to shift in a hawkish direction compared with its current projections, it is highly unlikely to become meaningfully more hawkish than current market expectations unless economic growth and the recovery in the labor market is much stronger than the Fed or the market is projecting. In fact, even if the market’s expectations for the first Fed rate hike shift to mid-2022 over the coming several months, Chart I-13 highlights that the impact on the equity market is likely to be minimal unless investors shift up their expectations for the terminal Fed funds rate. The chart presents a fair value estimate for the 10-year Treasury yield based on the OIS-implied path of the Fed funds rate out to December 2024, and assumes that short rates ultimately rise to the Fed’s long-term Fed funds rate projection of 2.5%. The second fair value series assumes that the shape of the OIS curve stays the same, but shifts closer by 6 months. Chart I-13The Market’s Assumed Rate Hike Path And Terminal Rate Are Not Threatening For Stocks April 2021 April 2021 The chart underscores that the 10-year yield will rise to at most between 2-2.2% by the end of the year based on these scenarios. A shift forward in the timing of Fed rate hikes will impact the short end of the curve, but the long end will remain relatively unchanged if terminal rate expectations stay constant and the term premium on long-term bonds remains near zero. These levels would in no way be economically damaging nor threatening to stock market valuation. It is possible, however, that investor expectations for the neutral rate of interest (“r-star”) will shift higher once the pandemic is over, and we explore this risk to stocks in Section 2 of our report. For now, this remains a risk to our view rather than our expectation, but it is likely to remain an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Within fixed income, we recommend that investors maintain below-benchmark portfolio duration even though investors are already pricing in a more hawkish path for the Fed funds rate. First, Chart I-13 highlighted that yields at the long end of the curve are likely to continue to move modestly higher this year even if the projected path for the Fed funds rate remains relatively unchanged. But more importantly, barring a substantially negative development on the health or vaccine front that prolongs the pandemic, the risk appears to be clearly to the upside in terms of the timing of the first Fed rate hike and the terminal Fed funds rate. As such, from a risk-reward perspective, a long duration stance remains unattractive. We would also recommend overweighting US speculative over investment-grade corporate bonds, as spreads are not as historically depressed for the former than the latter (Chart I-14). Finally, in terms of the dimensions of equity market performance and the dollar, we recommend that investors overweight global ex-US equities vs. the US, overweight value vs. growth, overweight cyclicals vs. defensives, and overweight small vs. large caps. We are also bearish on the dollar on a 12-month time horizon. However, there are two caveats that investors should bear in mind. First, global cyclicals versus defensives (especially in equally-weighted terms) as well as small versus large caps have already mostly normalized not just the impact of the pandemic but as well that of the 2018-2019 Trump trade war (Chart I-15). We would expect, at best, modest further gains from both positions this year. Chart I-14Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Chart I-15Going Forward, Expect More Modest Gains From Cyclicals And Small Caps Going Forward, Expect More Modest Gains From Cyclicals And Small Caps Going Forward, Expect More Modest Gains From Cyclicals And Small Caps   Second, the fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar on a 0-3 month time horizon. The US dollar is typically a counter-cyclical currency, but there have been exceptions to that rule. And historically, exceptions have tended to revolve around periods when US growth has been quite strong, as is currently the case (Chart I-16). A continued counter-trend rally in the dollar is thus possible over the course of the next few months, but we would expect USD-EUR to be lower than current levels 12 months from now. Chart I-16A Short-Term Counter-Trend Dollar Move Is Possible A Short-Term Counter-Trend Dollar Move Is Possible A Short-Term Counter-Trend Dollar Move Is Possible A counter-trend dollar move could also correspond with a period of US outperformance versus global ex-US, or at a minimum, a period of flat performance when global ex-US stocks would normally outperform. Our China strategists expect that the Chinese credit impulse will decelerate later this year (Chart I-17), which would weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. Chart I-18 highlights that euro area equity underperformance versus the US last year was mostly a tech story, but today there is little difference between the relative performance of euro area stocks overall versus indexes that exclude the broadly-defined technology sector. In both cases, the euro area index is roughly 10% below its US counterpart relative to pre-pandemic levels, which exactly matches the extent to which euro area financials have underperformed. Chart I-17A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform Chart I-18Euro Area Financials Need To Outperform For Europe To Outperform Euro Area Financials Need To Outperform For Europe To Outperform Euro Area Financials Need To Outperform For Europe To Outperform   Euro area financials have demonstrated very poor fundamental performance over the past decade, but they are likely to outperform for some period once the European vaccination campaign gains enough traction to alter the disease’s transmission and hospitalization dynamics. Chart I-19 highlights that euro area bank 12-month forward earnings have further room to recover to pre-pandemic levels than for banks in the US, and Chart I-20 highlights that euro area banks trade at their deepest price-to-book discount versus their US peers since the euro area financial crisis. Chart I-19Euro Area Bank Earnings Have Catch-Up Potential Euro Area Bank Earnings Have Catch-Up Potential Euro Area Bank Earnings Have Catch-Up Potential Chart I-20Euro Area Banks Are Extremely Cheap Versus The US Euro Area Banks Are Extremely Cheap Versus The US Euro Area Banks Are Extremely Cheap Versus The US   Thus, while euro area and global ex-US equities may not outperform on the back of rising global stock prices over the coming few months, investors focused on a 6-12 month time horizon should respond by increasing their allocation to European stocks and to further reduce dollar exposure. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst March 31, 2021 Next Report: April 29, 2021 II. R-star, And The Structural Risk To Stocks In the decade following the global financial crisis, investor concerns that the Fed’s monetary policies have artificially boosted equity market valuation have been mostly overblown. But today, it is now true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid near bubble-like relative pricing if yields remain below trend rates of economic growth. Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. A gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but in the few years prior to the pandemic, it is altogether possible that the neutral rate of interest (or “r-star”) was in fact meaningfully higher than academic estimates suggested. In a scenario where the US output gap closes quickly, inflation rises above target, and where permanent damage to the labor market from the pandemic is relatively limited, we expect the narrative of secular stagnation to be challenged and for investor expectations for the neutral rate to move closer to trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, and possibly as high as 4% or more. Such a shift would push the US equity risk premium back to 2002 levels based on current stock market pricing. This is not necessarily negative for equities, but it is also not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. A low ERP that is technically not as low as that of the tech bubble era could thus still threaten stock prices, as T.I.N.A., “There Is No Alternative,” may not prevail. Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. While they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. Chart II-1Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... For the better part of the last decade, many investors have argued that the Fed’s monetary policies have artificially boosted equity market valuation. Based on the cyclically-adjusted P/E ratio metric originated by Robert Shiller, stocks reached pre-global financial crisis (GFC) multiples in late 2014 and early 2015 (Chart II-1). Based on metrics such as the price-to-sales ratio, stocks rose to pre-GFC valuation in late 2013, and are now even more richly valued than they were at the height of the dotcom bubble. These concerns have mostly occurred in response to absolute changes in stock multiples, but equity valuation cannot be divorced from the prevailing level of interest rates. Relative to bond yields, stocks were extraordinarily cheap for many years following the GFC. Measured by one simple approach to calculating the equity risk premium, the spread between the 12-month forward earnings yield (the inverse of the forward P/E ratio) and the real 10-year Treasury yield, stocks were the cheapest following the GFC that they had been since the mid 1980s, and remain reasonably priced today (Chart II-2). Chart II-2...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds The fact that stocks have appeared to be expensive for several years but quite cheap (or reasonably priced) relative to bonds underscores the fact that longer-term bond yields have been extraordinarily low following the global financial crisis. Still, equities were not dependent on low bond yields prior to the pandemic, as illustrated in Chart II-3. The chart highlights the range of 10-year Treasury yields that would be consistent with the pre-GFC equity risk premium range (measured from 2002-2007), alongside the actual 10-year yield and trend nominal GDP growth. The chart shows that for years following the financial crisis, bond yields could have risen to levels well above trend rates of economic growth and stocks would still have been priced in line with pre-crisis norms. This “normal pricing” range for the 10-year declined as the expansion continued, but remained consistent with trend growth rates and above the actual 10-year yield up until the beginning of the pandemic. Chart II-3 also highlights, however, that the circumstances changed last year. The equity risk premium briefly rose at the onset of the pandemic as stocks initially sold off sharply, but then quickly fell as stock prices recovered in response to aggressive fiscal and monetary easing. Today, it is true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid bubble-like relative pricing if yields remain below trend rates of economic growth. Chart II-3Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Prior to the pandemic, most fixed-income investors would have viewed the risk of bond yields rising to trend nominal GDP growth, let alone above it, as minimal. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to academic estimates of the neutral rate of interest (“R-star”) that show a substantial gap between the natural rate and trend real growth (Chart II-4). This view has manifested itself in a decline in surveyed estimates of the long-run Fed funds rate, but at present the 5-year/5-year forward Treasury yield has pushed well above this survey-derived fair value range (Chart II-5). It is possible that the fiscal response to the pandemic will cause investor views about r-star to evolve even further over the coming 12-24 months, and in this report we explore the potential headwind that such an evolution could present to stock prices at some point – potentially as early as next year. Chart II-4Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Chart II-5The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting   R-star: A Brief Primer Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. From the perspective of macro theory, the neutral rate of interest is determined by the supply of and demand for savings. But in practical terms, this implies that the neutral rate should normally be closely linked to the trend rate of economic growth. For example, if interest rates – and thus the cost of capital – were persistently below aggregate income growth, then demand for capital (and thus credit and likely labor demand) should increase as firms seek to profit from the gap between the interest rate and the expected rate of return from real investment. As such, the trend rate of growth acts as a good proxy for the interest rate that will balance the supply and demand for credit during normal economic circumstances. Empirically, academic estimates of r-star closely followed estimates of trend real GDP growth prior to the global financial crisis, as shown in Chart II-4 above. In addition, we noted in our January report that the stance of monetary policy, as defined by the difference between nominal GDP growth and the 10-year Treasury yield, has generally done a good job of explaining the US output gap prior to 2000. This supports the notion that monetary policy is stimulative (restrictive) when bond yields are below (above) trend growth rates. However, in the years following the GFC, investors’ estimates of r-star collapsed, as evidenced by the sharp decline in 5-year / 5-year forward Treasury yields (Chart II-6). This was followed by a decline in primary dealer and FOMC expectations for the long-term Fed funds rate, which investors took as validating their view that the neutral rate of interest has permanently declined. Chart II-6Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate R-star And Trend Growth: Is A Gap Between The Two Really Justified? Chart II-7R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) It seems clear that r-star did indeed decline for a time after the GFC. The US and select European economies suffered a balance sheet recession in 2008/2009 that impacted credit demand for an extended period of time (Chart II-7), and extraordinarily low interest rates for several years did not fuel major credit excesses (at least in the household sector). But as we detailed in a Special Report last year,2 we doubt that the decline in r-star was permanent, for several reasons. The first, and most important, is that there have been at least four deeply impactful non-monetary shocks to both the US and global economies since 2008 that magnified the impact of prolonged household deleveraging and help explain the disconnect between growth and interest rates during the last economic cycle: The euro area sovereign debt crisis Premature fiscal austerity in the US, the UK, and euro area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The Trump administration’s aggressive use of tariffs beginning in 2018, impacting China but also other developed market economies. Chart II-8Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Except for the oil price shock of 2014 (which was driven by technological developments and a price war among producers), all of these non-monetary shocks were caused or exacerbated by policymakers – often for political reasons or due to regulatory failures. Second, the trend in US private sector credit growth last cycle does not suggest that r-star fell permanently. Chart II-8 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it started growing again in 2013 and had largely closed the gap with income growth prior to the pandemic. The second point is that the nonfinancial corporate sector clearly leveraged itself over the course of the last expansion, arguing that interest rates have not in any way been restrictive for businesses. Third, we disagree with a common view in the marketplace that the 2018-2019 period supported the validity of low academic estimates of the neutral rate. Chart II-9 highlights that monetary policy ceased to be stimulative in 2019 according to the Laubach & Williams r-star estimate, which some investors have argued explains the late 2018 equity market selloff, the 2019 slowdown in the US housing market, the inversion of the yield curve, and the global manufacturing recession. Chart II-9Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate But this narrative ignores other important factors that contributed to the slowdown. For example, Chart II-10 highlights that this period of economic weakness exactly coincided with the most intense phase of the Sino-US trade war, as well as a significant slowdown in Chinese credit growth. The chart highlights that the selloff in the US equity market began almost immediately after a surge in the effective tariff rates levied by the two countries against each other, and after the Chinese credit impulse fell three percentage points (from 30% to 27% of GDP). Chart II-10The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded Chart II-11 highlights that interest rates did likely impact the housing market, but that it was the speed at which rates rose that was damaging rather than their level. The chart shows that the rise in mortgage rates from late 2016 to late 2018 was among the largest 2-year increases that has occurred since the early 1980s, so it is unsurprising that the growth in home sales and real residential investment slowed for a time. Additionally, Chart II-12 highlights that the rise in mortgage rates during this period did not cause a downtrend in mortgage credit growth, which only occurred in Q4 2018 in response to the impact of the sharp selloff in the equity market on household net worth. Chart II-11Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Chart II-12A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market   In short, the late 2018 / 2019 period saw a major global aggregate demand shock occur following an already-established slowdown in Chinese credit growth and a rapid rise in interest rates in the DM world. It is these factors that were likely responsible for the 2019 slowdown in economic growth, not the fact that interest rates reached levels that restricted economic activity on their own. R-star In A Post-Pandemic World Charts II-7 – II-12 above suggest that a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in r-star only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand. In the few years prior to the pandemic, it is altogether possible that r-star was in fact meaningfully higher than academic estimates suggested. But that is now a counterfactual assertion, as the pandemic has transformed the outlook for interest rates and bond yields in conflicting ways. A 10% decline in the level of real output was the most intensely negative non-monetary shock to aggregate demand since the 1930s (Chart II-13), and we agree that another depression would have occurred without extraordinary government assistance. The economic damage caused by the pandemic certainly does not work in favor of a higher neutral rate, and we highlighted in Section 1 of our report that the Fed expects there to be some lingering and persistent slack in the labor market even once the pandemic is over. Chart II-13Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Chart II-14A Huge Increase In Government Transfers And Spending Is Underway April 2021 April 2021 On the other hand, Larry Summers, the chief proponent of the theory of secular stagnation, has argued for several years that increased fiscal spending was warranted in order to address an imbalance between private sector savings and investment. Summers himself now characterizes US fiscal policy as the “least responsible” that he has seen over the past 40 years, because of too-large government spending that risks overheating the economy (Chart II-14). Summers’ critique rests in large part on the fact that new government spending has not occurred in the form of investment (to balance out the existence of excess savings), but is instead providing transfers to households that in many cases have already accumulated significant excess savings. But the key point for investors is that the pandemic has completely shifted the narrative about fiscal spending, from “arguably insufficient for several years following the global financial crisis” to now “risking a dramatic overheating of the economy.” Some elements of Summers’ criticism of the Biden administration’s fiscal policy are justified, particularly the policy of large direct transfer payments to workers who have suffered no loss in employment or income as a result of the pandemic. Despite this, as detailed in Section 1 of our report, we are more sanguine about the risks of aggressive overheating for three reasons: it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return or will be slow to return, some of the excess savings that have accumulated will not be immediately (or ever) spent, and the rise in consumer inflation expectations that has occurred over the past year has happened from an extremely low starting point and has yet to even rise above its post-GFC range. The low odds that we assign to dangerously above-target inflation over the coming 12-24 months does not, however, mean that investors’ expectations for r-star will stay low. For right or for wrong, the US government has aggressively dis-saved over the past year, in an environment where low expectations for the neutral rate were anchored by a view of excessive private sector savings and insufficient demand from governments. In a scenario where the US output gap closes quickly, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited, it seems reasonable to conclude that the narrative of secular stagnation will be challenged and that investor expectations for the neutral rate will converge towards trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, possibly as high as 4% or more. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions A rise in the 5-year/5-year forward Treasury yield does not, in and of itself, suggest that 10-year Treasury yields will rise to levels that would threaten a significant decline in stock prices. The Fed does not control the long-end of the Treasury curve, but it does exert a very strong influence on the short-end. For example, were the Fed to follow the median current projection of FOMC participants and refrain from raising interest rates until sometime after 2023, it would limit how high current 10-year Treasury yields could rise. But it is not difficult to envision plausible scenarios where the 10-year Treasury yield rises above the range consistent with the pre-GFC US equity risk premium. Chart II-15 presents three hypothetical fair value paths for the 10-year yield assuming a mid-2022 liftoff date and a 4% terminal Fed funds rate for the following three scenarios: Chart II-1510-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 10 basis points The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 50 basis points The Fed raises rates at a pace of 1.5% (6 hikes) per year, with a term premium of 50 basis points In the first scenario, based on the current US 12-month forward P/E ratio, the fair value of the 10-year Treasury yield would rise above the range consistent with a reasonable ERP in the middle of 2022, the liftoff point assumed in all three scenarios. In the second and third scenarios, the US equity ERP would already be quite low. When using the late 1999 / early 2000 bubble period as a reference point, even the scenarios shown in Chart II-15 are not very threatening to stock prices. Given current equity market pricing, the third scenario would take the US equity risk premium back to mid 2002 levels, which were still meaningfully higher than during the peak of the bubble. And that is assuming an earlier liftoff than the market currently expects, a faster pace of rate hikes than experienced during the last economic cycle, and a very meaningful increase in the market’s expectations for the neutral rate. But it is not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. For example, equity investors are today faced with a riskier policy environment than existed 20 years ago in the US and in other developed economies that is at least partially driven by populist sentiment, potentially impacting earnings via lower operating margins or higher taxes. These or other risks existed at several points over the past decade and T.I.N.A. (“There Is No Alternative”) prevailed, but that occurred precisely because the equity risk premium was very elevated. A low ERP that is technically not as low as what prevailed during the tech bubble era could thus still threaten stock prices, raising the specter of negative absolute returns from stocks and nominal government bonds for a period of time, beginning potentially at or in the lead-up to the first Fed rate hike. Chart II-16There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. Chart II-16 provides some perspective on the question, by comparing the total return of a 60/40 stock/bond portfolio to a strategy involving the opportunistic redeployment of cash into stocks. The strategy rule maintains a 50/50 stock/cash allocation during normal market conditions, but it then shifts the entire cash allocation into equities following a 15% selloff in the stock market. The portfolio is shifted back to a 50/50 allocation once stocks rise to a new rolling 1-year high. The chart highlights that 60/40 balanced portfolio-style returns may be achievable with cash as the diversifier without a significant reduction in the Sharpe ratio. In fact, the strategy has the effect of lowering average volatility due to prolonged periods of comparatively lower equity exposure, although this occurs at the cost of higher volatility during periods of high market stress (precisely when investors most want protection from volatility). But the bottom line for investors is that while they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. As noted above, this remains a risk to our view rather than our expectation, but we will continue to monitor the potential threat posed to stock prices as the pandemic draws to a decisive close later this year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have ticked slightly lower from their strongest levels on record. Within a global equity portfolio, US stocks have recently risen versus global ex-US, reflecting a countertrend rise in the US dollar and a lagging vaccination campaign in Europe. We expect a deceleration in the Chinese credit impulse later this year, which will weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. The US 10-Year Treasury yield has risen well above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields could move higher over the cyclical investment horizon. The recent bounce in the US dollar has reflected improved relative US growth expectations, but also previously oversold levels. The dollar may continue to strengthen on a 0-3 month time horizon, but we expect it to be lower in 12 months’ time than it is today. Commodity prices have recovered not just back to pre-pandemic levels, but also back to 2014 levels. This underscores that many commodity prices are extended, and may be due for a breather once the Chinese credit impulse begins to decline. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. This underscores that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2  2020-03-20 GIS SR “Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis.”

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, April 1 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Growth outlook: The global economy will rebound over the course of the year, with momentum rotating from the US to the rest of the world. Inflation: Structurally higher inflation is not a near-term risk, even in the US, but could become a major problem by the middle of the decade. Global asset allocation: Investors should continue to overweight equities on a 12-month horizon. Unlike in the year 2000, the equity earnings yield is still well above the bond yield. Equities: Value stocks will maintain their recent outperformance. Investors should favor banks and economically-sensitive cyclical sectors, while overweighting stock markets outside the US. Fixed income: Continue to maintain below average interest-rate duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: While the dollar could strengthen in the near term, it will weaken over a 12-month period. Large budget deficits, a deteriorating balance of payments profile, and an accommodative Fed are all dollar bearish. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Strong Chinese growth will continue to buoy the metals complex. I. Macroeconomic Outlook Global Growth: The US Leads The Way… For Now The global economy should rebound from the pandemic over the remainder of the year. So far, however, it has been a two-speed recovery. Whereas the Bloomberg consensus has US real GDP growing by 4.8% in the first quarter, analysts expect the economies in the Euro area, UK, and Japan to contract by 3.6%, 13.3%, and 5%, respectively. Chart 1Dismantling Of Lockdown Measures Occurring At Varying Pace Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 2US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders Two things explain US growth outperformance. First, the successful launch of the US vaccination campaign has allowed state governments to begin dismantling lockdown measures (Chart 1). Currently, the US has administered 40 vaccine shots for every 100 inhabitants. Among the major economies, only the UK has performed better on the vaccination front (Chart 2). In contrast, parts of continental Europe are still battling a new wave of Covid infections, prompting policymakers there to further tighten social distancing rules. Second, US fiscal policy has been more stimulative than elsewhere (Chart 3). On March 11, President Biden signed the $1.9 trillion American Rescue Plan Act into law. Among other things, the Act provides direct payments to lower- and middle-class households, extends and expands unemployment benefits, and offers aid to state and local governments (Chart 4). Unlike President Trump’s Tax Cuts and Jobs Act, the Democrats’ legislation will raise the incomes of the poor much more than the rich (Chart 5). Chart 3The US Tops The Stimulus Race Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? We expect growth leadership to shift from the US to the rest of the world in the second half of the year. Nevertheless, US real GDP in Q4 of 2021 will probably end up 7% above the level of Q4 of 2020, enough to close the output gap. In Section II of this report, we discuss whether this could cause inflation to take off on a sustained basis. We conclude that such an outcome is unlikely for the next two years. However, materially higher inflation is indeed a risk over a longer-term horizon. Chart 4Composition Of The American Rescue Plan Act Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 5Biden’s Package Will Boost The Income Of The Poor More Than The Rich Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   The EU: Recovery After Lockdown The EU will benefit from a cyclical recovery later this year as the vaccination campaign picks up steam. The recent weakness in Europe was concentrated in services (Chart 6). The latest European PMI data shows that the service sector may have turned the corner. As in the US, European households have accumulated significant excess savings. The unleashing of pent-up demand should drive consumption over the remainder of the year (Chart 7). Chart 6For Now, The Service Sector Is Doing Better In The US Than The Euro Area Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 7European Households Have Accumulated Excess Savings European Households Have Accumulated Excess Savings European Households Have Accumulated Excess Savings Meanwhile, the manufacturing sector continues to do well, with the Euro area manufacturing PMI hitting all-time highs in March. Sentiment indices such as the Sentix and ZEW surveys point to further upside for manufacturing activity (Chart 8).   Chart 8Positive Outlook For Euro Area Manufacturing Activity Positive Outlook For Euro Area Manufacturing Activity Positive Outlook For Euro Area Manufacturing Activity Fiscal policy should also turn modestly more expansionary. The EU recovery fund will begin disbursing aid in the second quarter. This should allow the southern European economies to maintain more generous levels of fiscal support. It also looks increasingly likely that the Green Party will either lead or join the coalition government in Germany, which could translate into greater spending. UK: Recovering From A One-Two Punch The UK had to shutter its economy late last year due to the emergence of a new, more contagious, strain of the virus. The resulting hit to the economy came on top of a decline in exports to the EU following Brexit. The economic picture will improve over the coming months. Thanks to the speedy vaccination campaign, the government plans to lift the “stay at home” rules on March 29. Most retail, dining, and hospitality businesses are scheduled to reopen on April 12. A strong housing market and the extension of both the furlough schemes and tax holidays should also sustain demand. Japan: More Fiscal Support Needed Like many other countries, Japan had to introduce new lockdown measures in late 2020 after suffering its worst wave of the pandemic. While the number of new cases has dropped dramatically since then, they have edged up again over the past two weeks. Japanese regulations require that vaccines be tested on Japanese people. Prime Minster Yoshihide Suga has promised that vaccine shots will be available to the country’s 36 million seniors by the end of June. However, with less than 1% of the population vaccinated so far, strict social distancing will persist well into the summer. The Japanese government passed a JPY 73 trillion (13.5% of GDP) supplementary budget in December. However, only 40 trillion of that has been allocated for direct spending. Due to negative bond yields, the Japanese government earns more interest than it pays on its debt. It should be running much more expansionary fiscal policy. China: Policy Normalization, Not Deleveraging Chart 9China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China’s combined credit/fiscal impulse peaked late last year (Chart 9). The impulse leads growth by about six months, implying that the tailwind from easier monetary and fiscal policies will fade over the rest of the year. Nevertheless, we doubt that China’s economy will experience much of a slowdown. First and foremost, the shock from the pandemic should fade, helping to revive consumer and business confidence. Second, the Chinese authorities are likely to pursue policy normalization, rather than outright deleveraging. Jing Sima, BCA’s chief China strategist, expects the general government deficit to remain broadly stable at 8% of GDP this year. She also thinks that the rate of credit expansion will fall by only 2-to-3 percentage points in 2021, bringing credit growth back in line with projected nominal GDP growth of 8%. Total credit was 290% of GDP at end-2020. Thus, credit growth of 8% would still generate 290%*8%=23% of GDP of net credit formation, providing more than enough support to the economy. II. Feature: Will The US Economy Overheat? As of February, US households were sitting on around $1.7 trillion in excess savings. About two-thirds of those savings can be chalked up to reduced spending during the pandemic, with the remaining one-third arising from increased transfer payments (Chart 10). The recently passed stimulus bill will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. This cash hoard will support spending. Already, real-time measures of economic activity have hooked up. Traffic congestion in many US cities is approaching pre-pandemic levels. OpenTable’s measure of restaurant occupancy is progressing back to where it was before the pandemic (Chart 11). J.P. Morgan reported that spending using its credit cards rose 23% year-over-year in the 9-day period through to March 19 as stimulus payments reached bank accounts. Anecdotally, airlines and cruise line companies have been expressing optimism on the back of a surge in bookings. Chart 10Lower 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 11Real-Time Measures Of Economic Activity Have Hooked Up Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   Meanwhile, the supply side of the economy could face temporary constraints. Under the stimulus bill, close to half of jobless workers will receive more income through to September from extended unemployment benefits than they did from working. This could curtail labor supply at a time when firms are trying to step up the pace of hiring. The Fed Versus The Markets In the latest Summary of Economic Projections released last week, the median “dot” for the fed funds rate remained stuck at zero through to end-2023. The bond market, in contrast, expects the Fed to start raising rates next year. Why is there a gap between the Fed and market expectations? Part of the answer is that the “dots” and market expectations measure different things. Whereas the dots reflect a modal, or “most likely” estimate of where short-term rates will be over the next few years, market expectations reflect a probability-weighted average. The fact that rates cannot fall deeply into negative territory – but can potentially rise a lot in a high-inflation scenario – has skewed market rate expectations to the upside. That said, there is another, more fundamental, reason at work: The Fed simply does not think that a negative output gap will lead to materially higher inflation. The “dots” assume that core PCE inflation will barely rise above 2% over the next two years, even though, by the Fed’s own admission, the unemployment rate will fall firmly below NAIRU in 2023 (Chart 12). Chart 12The Fed Sees Faster Recovery, Same Rate Path Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 13Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Is the Federal Reserve’s relaxed view towards inflation risk justified? The Fed knows full well that headline inflation could temporarily reach 4% over the next two months due to base effects from last year’s deflationary shock, lingering supply chain disruptions, the rebound in gasoline prices, and the lagged effect from dollar weakness. However, as it did in late 2011, when headline inflation nearly hit 4% and producer price inflation briefly topped 10%, the Fed is inclined to regard these price shocks as transitory (Chart 13). The Fed believes that PCE inflation will tick up to 2.4% this year but then settle back down to 2% by the end of next year as supply disruptions dissipate and most fiscal stimulus measures roll off. Our bet is that the Fed will be right about inflation in the near term, but wrong in the long term. That is to say, we think that core inflation will probably remain subdued for the next two years, as the Fed expects. However, inflation is poised to rise significantly towards the middle of the decade, an outcome that is likely to surprise both the Fed and market participants. War-Time Inflation, But Which War? In some respects, the Fed sees the current environment as resembling a war, except this time the battle is against an invisible enemy: Covid-19. Chart 14 shows what happened to US inflation during WWI, WWII, the Korean War, and the Vietnam War. In the first three of those four wars, inflation rose but then fell back down after the war had concluded. That is what the Fed is counting on. What about the possibility that the coming years could resemble the period around the Vietnam War, where inflation continued to rise even though the number of US military personnel engaged in the conflict peaked in 1968?   Chart 14Inflation During Wartime: Which War Is Most Relevant For Today? Inflation During Wartime: Which War Is Most Relevant For Today? Inflation During Wartime: Which War Is Most Relevant For Today? Chart 15Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In the near term, this does not appear to be a major risk. In 1966, when the war effort was ramping up, the US unemployment rate was two percentage points below NAIRU (Chart 15). As of February, US employment was still more than 5% below pre-pandemic levels.   Chart 16Employment Has Been Weak And Edging Lower At The Bottom Quartile Of The Wage Distribution Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? We estimate that the US output gap currently stands at around 5%-to-6% of GDP. Among the bottom quartile of the wage distribution, employment is 20% below pre-pandemic levels, and has been edging lower, not higher, since last October (Chart 16). Thus, for now, hyperbolic talk of how fiscal stimulus is crowding out private-sector spending is unwarranted. Inflation Nation Looking further out, the parallels between today and the late sixties are more striking. As we discussed in a report titled 1970s-Style Inflation: Yes, It Could Happen Again, much of what investors believe about how inflation emerged during the late 1960s is either based on myths, or at best, half-truths. To the extent that there are differences between today and that era, they don’t necessarily point to lower inflation in the coming years. For example, in the late sixties, the baby boomers were entering the labour force, supplying the economy with a steady stream of new workers. This helped to temper wage pressures. Today, baby boomers are leaving the labour force. They accumulated a lot of wealth over the past 50 years – so much so that they now control more than half of all US wealth (Chart 17). Over the coming two decades, they will run down that wealth, implying that household savings rates could drop. By definition, a lower savings rate implies more spending in relation to output, which is inflationary. Chart 17Baby Boomers Have Accumulated A Lot Of Wealth Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? III. Financial Markets A. Portfolio Strategy Overweight Stocks Versus Bonds Stocks usually outperform bonds when economic growth is strong and money is cheap (Chart 18). The end of the pandemic and ongoing fiscal stimulus should support growth over the next 12-to-18 months, allowing the bull market in equities to continue. With inflation slow to rise, monetary policy will remain accommodative over this period. Chart 18AStocks Usually Outperform Bonds When Economic Growth Is Strong... Stocks Usually Outperform Bonds When Economic Growth Is Strong... Stocks Usually Outperform Bonds When Economic Growth Is Strong... Chart 18B... And Money Is Cheap ... And Money Is Cheap ... And Money Is Cheap The recent back-up in long-term bond yields could destabilize stocks for a month or two. However, our research has shown that as long as bond yields do not rise enough to trigger a recession, stocks will shrug off the effect of higher yields (Chart 19 and Table 1). Indeed, there is a self-limiting aspect to how high bond yields can rise, and stocks can fall, in a setting where inflation remains subdued. Higher bond yields lead to tighter financial conditions. Tighter financial conditions, in turn, lead to weaker growth, which justifies an even longer period of low rates. It is only when inflation rises to a level that central banks find uncomfortable that tighter financial conditions become desirable. We are far from that level today. Chart 19What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise?   Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   It’s Not 2000 In recent months, many analysts have drawn comparisons between the year 2000 and the present day. While there are plenty of similarities, ranging from euphoric retail participation to the proliferation of dubious SPACs and IPOs, there is one critical difference: The forward earnings yield today is above the real bond yield, whereas in 2000 the earnings yield was below the bond yield (Chart 20). The US yield curve inverted in February 2000, with the 10-year Treasury yield peaking a month earlier at 6.79%. An inverted yield curve is one of the most reliable recession predictors. We are a far cry from such a predicament today. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 20% in real terms for equities to underperform bonds. Many other stock markets would have to decline by an even greater magnitude (Chart 21). Chart 20Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Chart 21Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds   Protecting Against Long-Term Inflation Risk The bull market in stocks will end when central banks begin to fret over rising inflation. In the past, central banks have used forecasts of inflation to decide when to raise rates. The Federal Reserve’s revised monetary policy framework, which focuses on actual rather than forecasted inflation, almost guarantees that inflation will overshoot the Fed’s target. This is because monetary policy fully affects the economy with a lag of 12-to-18 months. By the time the Fed decides to clamp down on inflation, it will have already gotten too high. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios, favor inflation-protected securities over nominal bonds, and own more “real assets” such as property. In fact, one of the best inflation hedges is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades, you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms. Gold Versus Cryptos Historically, gold has offered protection against inflation. Increasingly, many investors have come to believe that cryptocurrencies are a better choice. We disagree. As we recently discussed in a report titled Bitcoin: A Solution In Search Of A Problem, not only are cryptocurrencies such as Bitcoin highly inefficient mediums of exchange, they are also likely to turn out to be poor stores of value. Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 22). About 70% of Bitcoin mining currently takes place in China, mainly using electricity generated by burning coal. Much of the rest of the mining takes place in countries such as Russia and Belarus with dubious governance records. Bitcoin and ESG are heading for a clash. We suspect ESG will win out. Chart 22Bitcoin Is Not Your Eco-Currency Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? B. Equities Favor Cyclicals, Value, And Non-US Stocks Chart 23Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing The vast majority of stock market capitalization today is concentrated in large multinational companies that are more leveraged to global growth rather than to the growth rate of countries in which they happen to be domiciled. Thus, while country-specific factors are not irrelevant, regional equity allocation often boils down to figuring out which stock markets will gain or lose from various global trends. The end of the pandemic will prop up global growth. In general, cyclical sectors outperform when global growth is on the upswing (Chart 23). As Table 2 illustrates, stock markets outside the US have more exposure to classically cyclical sectors such as industrials, energy, materials, and consumer discretionary that usually shine coming out of a downturn. This leads us to favor Europe, Japan, and emerging markets. We place banks in the cyclical category because faster economic growth tends to reduce bad loans, while also placing upward pressure on bond yields. Chart 24 shows that there is a very close correlation between the relative performance of bank shares and long-term bond yields. As government yields trend higher, banks will benefit. Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 24Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Banks and most other cyclical sectors dominate value indices (Table 3). Not only is value still exceptionally cheap in relation to growth, but traditional value sectors have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 25). The likelihood that global bond yields put in a secular bottom last year, coupled with the emergence of a new bull market in commodities, makes us think that the nascent outperformance of value stocks has years to run.   Table 3Breaking Down Growth And Value By Sector Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 25AValue Is Attractive On Multiple Levels (I) Value Is Attractive On Multiple Levels (I) Value Is Attractive On Multiple Levels (I) Chart 25BValue Is Attractive On Multiple Levels (II) Value Is Attractive On Multiple Levels (II) Value Is Attractive On Multiple Levels (II) US Corporate Tax Hikes Coming Finally, there is one country-specific factor worth mentioning, which reinforces our view of favoring non-US, cyclical, and value stocks: US corporate taxes are heading higher. BCA’s geopolitical strategists expect the Biden Administration and the Democrat-controlled Congress to raise the statutory corporate tax rate from 21% to as high as 28% later this year in order to fund, among other things, a major infrastructure investment program. Capital gains taxes will also rise. While tax hikes are unlikely to bring down the whole US stock market, they will detract from the relative performance of US stocks compared with their international peers. Cyclical sectors will benefit from the infrastructure spending. To the extent that such spending boosts growth and leads to a steeper yield curve, it should also benefit banks. In contrast, tech companies outside the clean energy sector will lag, especially if the bill introduces a minimum corporate tax on book income and raises taxes on overseas profits, as President Biden pledged to do during his campaign. C. Fixed Income Expect More US Curve Steepening As discussed above, inflation in the US and elsewhere will be slow to take off. However, when inflation does rise later this decade, it could do so significantly. Investors currently expect the Fed to start raising rates in December 2022, bringing the funds rate to 1.5% by the end of 2024 (Chart 26). In contrast, we think that a liftoff in the second half of 2023, preceded by a 6-to-12 month period of asset purchase tapering, is more likely. This implies a modest downside for short-dated US bond yields. Chart 26The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 Chart 27Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels In contrast, long-term yields will face upward pressure first from strong growth, and later from higher inflation. The 5-year/5-year forward TIPS yield currently stands at 0.35%, which is still below pre-pandemic levels (Chart 27). Given structurally looser fiscal policy, the 5-year/5-year forward TIPS yield should be at least 50 basis points higher, which would translate into a 10-year Treasury yield of a bit over 2%. Regional Bond Allocation While the Fed will be slow out of the gate to raise rates, most other central banks will be even slower. The sole exception among developed market central banks is the Norges bank, which has indicated its intention to hike rates in the second half of this year. Conceivably, Canada could start tightening monetary policy fairly soon, given strong jobs growth and a bubbly housing market. While the Bank of Canada is eager to begin tapering asset purchases later this year, our global fixed-income strategists suspect that the BoC will wait for the Fed to raise rates first. An early start to rate hikes by the Bank of Canada could significantly push up the value of the loonie, which is something the BoC wants to avoid. New Zealand will also hike rates shortly after the Fed, followed by Australia. Bank of England governor Andrew Bailey has downplayed the recent rise in gilt yields. Nevertheless, the desire to maintain currency competitiveness in the post-Brexit era will prevent the BoE from hiking rates until 2024. Among the major central banks, the ECB and the BoJ will be the last major central banks to raise rates. Putting it all together, our fixed-income strategists advocate maintaining a below-benchmark stance on overall duration. Comparing the likely path for rate hikes with market pricing region by region, they recommend overweighting the Euro area and Japan, assigning a neutral allocation to the UK, Canada, Australia, and New Zealand, and an underweight on the US. Credit: Stick With US High Yield Corporates Corporate spreads have narrowed substantially since last March. Nevertheless, in an environment of strong economic growth, it still makes sense to favor riskier corporate credit over safe government bonds. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over Euro area bonds. The former trade with a higher yield and spread than the latter (Chart 28). CHART 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Chart 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit-sensitive asset starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the middle of the distribution. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the Euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 29). Chart 29US High-Yield Stands Out The Most Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? D. Currencies Faster US Growth Should Support The Dollar In The Near Term… Chart 30US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The US has a “low beta” economy. Compared to most other economies, the US has a bigger service sector and a smaller manufacturing base (Chart 30). The US economy is also highly diversified on both a regional and sectoral level. This tends to make US growth less volatile than growth abroad. The relatively low cyclicality of the US economy has important implications for the US dollar. While the US benefits from stronger global growth, the rest of the world usually benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, dragging down the value of the dollar. This relationship broke down this year. Rather than lagging other economies, the US economy has led the charge thanks to bountiful fiscal stimulus and a successful vaccination campaign. As growth estimates for the US have been marked up, the dollar has caught a temporary bid (Chart 31). Chart 31US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar … But Underlying Fundamentals Are Dollar Bearish As discussed earlier in the report, growth momentum should swing back towards the rest of the world later this year. This should weigh on the dollar in the second half of the year. To make matters worse for the greenback, the US trade deficit has ballooned in recent quarters. The current account deficit, a broad measure of net foreign income flows, rose by nearly 35% to $647 billion in 2020. At 3.1% of GDP, it was the largest shortfall in 12 years (Chart 32). Consistent with the weak balance of payments picture, the dollar remains overvalued by about 10% on a purchasing power parity basis (Chart 33). Chart 32The Widening US External Gap The Widening US External Gap The Widening US External Gap Chart 33The Dollar Is Expensive Based On Its PPP Fair Value The Dollar Is Expensive Based On Its PPP Fair Value The Dollar Is Expensive Based On Its PPP Fair Value Historically, the dollar has weakened whenever fiscal policy has been eased in excess of what is needed to close the output gap (Chart 34). Foreigners have been net sellers of Treasurys this year. It is equity inflows that have supported the dollar (Chart 35). However, if non-US stock markets begin to outperform, foreign flows into US stocks could reverse. Chart 34The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs Chart 35Equity Inflows Supported The Dollar This Year (I) Equity Inflows Supported The Dollar This Year (I) Equity Inflows Supported The Dollar This Year (I) Chart 35Equity Inflows Supported The Dollar This Year (II) Equity Inflows Supported The Dollar This Year (II) Equity Inflows Supported The Dollar This Year (II) Meanwhile, stronger US growth has pushed long-term real interest rate differentials only modestly in favor of the US. At the short end of the curve, real rate differentials have actually widened against the US since the start of the year, reflecting rising US inflation expectations and the Fed’s determination to keep rates near zero for an extended period of time (Chart 36). Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) On balance, while the dollar could strengthen a bit more over the next month or so, the greenback will weaken over a 12-month horizon. Chester Ntonifor, BCA’s chief currency strategist, expects the dollar to fall the most against the Norwegian krone, Swedish krona, Australian dollar, and British pound over a 12-month horizon. In the EM space, stronger global growth will disproportionately benefit the Mexican peso, Chilean peso, Colombian peso, South African rand, Czech koruna, Indonesian rupiah, Korean won, and Singapore dollar. Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Consistent with our equity views, a weaker dollar would be good news for cyclical equity sectors, non-US stock markets, and value stocks (Chart 37). E. Commodities Favorable Outlook For Commodities Strong global growth against a backdrop of tight supply should sustain momentum in the commodity complex over the next 12-to-18 months. Capital investment in the oil and gas sector has fallen by more than 50% since 2014 (Chart 38). BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects annual growth in crude oil demand to outstrip supply over the remainder of this year (Chart 39). Chart 38Oil & Gas Capex Collapses In COVID-19’s Wake Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 39Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Chart 40). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of annual copper production. Chart 40ACopper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Chart 40B...As Will Aluminum ...As Will Aluminum ...As Will Aluminum China’s Commodity Demand Will Remain Strong Chart 41China Keeps Buying More And More Commodities China Keeps Buying More And More Commodities China Keeps Buying More And More Commodities Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 41). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Global Investment Strategy View Matrix Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Special Trade Recommendations Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Current MacroQuant Model Scores Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage Global Semiconductor Shortage Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 8Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls German Conservatives Waver in Polls German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 11Germany Puts Multilateralism To The Test Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 12UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues see Danny Crichton, Chris Miller, and Jordan Schneider, "Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors," Foreign Policy Research Institute, March 2021, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Tuesday, March 30 at 9:00 am HKT and Tuesday, March 30 at 10:00 am EDT. In the webcast, I will share our outlook on China’s post-pandemic economic and policy dynamics. Best regards, Jing Sima, China Strategist   Highlights China is aiming for a massive adoption of new energy vehicles (NEVs) to help achieve its 2030 peak carbon dioxide emissions target. The country’s NEV share of total vehicle sales will likely rise significantly to 40% in 2030, from only 5.4% in 2020. This will translate into a compound annual growth rate (CAGR) of 24%-25% in Chinese NEV sales in this decade. China will become increasingly competitive and important in the global NEV supply chain. The country will maintain its leading position in global electric vehicle battery production while reducing its dependence on imported auto chips.   The Chinese NEV production/sales boom will likely reduce the country’s crude oil consumption while increasing the country’s copper demand during 2021-2030. It will also impact more positively on nickel and lithium demand than on cobalt demand. The Chinese NEV stocks could be a good long-term investment, but we recommend waiting for a better entry point. Feature China's production and sales of new energy vehicles (NEVs) have ranked first in the world for six consecutive years. The country’s NEV sales quadrupled during 2015-2020, propelled by supporting policies such as significant amounts of subsidies to buyers.  We believe China will continue to be the leader in both global NEV sales and production this decade. The country’s NEV production and sales will get supercharged by continuing favorable polices and increasing consumers’ interest in NEVs. Many market-driven factors, including falling NEV prices, longer driving range per charge, rapid expansion in the NEV charging/battery-swapping network, as well as new functions including autonomous driving and more software applications-based services, will accelerate NEV adoption in China during 2021-2030. According to the country’s NEV development roadmap, the NEV share of total vehicle sales in China aims to rise to at least 40% in 2030, from only 5.4% in 2020. This will likely translate to a compound annual growth rate (CAGR) of 24%-25% in Chinese NEV sales in this decade. In 2030, the NEV sales in units could be eight to nine times its 2020 level, rising from 1.37 million units to 12-13 million units (Chart 1). Benefiting from the massive scale of the domestic NEV market, China will become increasingly competitive and important in the global NEV supply chain. The country will maintain its leading position in global electric vehicle battery production while reducing its dependence on imported auto chips. The Chinese NEV production/sales boom will help reduce transportation fuel consumption, leading to less carbon dioxide emissions (Chart 2).  Chart 1Chinese NEV Sales: A Supercharged Decade Ahead Chinese NEV Sales: A Supercharged Decade Ahead Chinese NEV Sales: A Supercharged Decade Ahead Chart 2China: Booming NEV Sales Reduce Oil Demand, Leading To Less CO2 Emissions China: Booming NEV Sales Reduce Oil Demand, Leading To Less CO2 Emissions China: Booming NEV Sales Reduce Oil Demand, Leading To Less CO2 Emissions In addition, the country’s copper demand will likely be increase due to booming NEV production during 2021-2030. Meanwhile, the impact will be more positive on nickel and lithium demand than on cobalt demand. Given such  significant growth ahead for the Chinese NEV market, we believe Chinese NEV-related stocks are a potential good buy, but we recommend waiting for a better entry point.   China’s NEV Market: A Supercharged Decade Chinese NEV market is entering a supercharged decade (Box 1). Box 1 Our Forecast Of China’s NEV Sales In 2030 Our estimates of China’s NEV sales in 2030 were derived from two assumptions. First, we assume the NEV share of total Chinese automobile sales in 2030 to be 40%. Based on last October’s report, “Technology Roadmap 2.0 for Energy-Saving and New Energy Vehicles,” published by the China Society of Automotive Engineers (China-SAE), the China-SAE projects that NEVs will account for at least 40% of total automobile sales in China in 2030. The China-SAE is under the supervision of the Ministry of Industry and Information Technology (MIIT). Second, as car ownership – the share of households owning one car – has already risen to over 50% in China, we assume the CAGR of the country’s automobile sales will slow to 1.5%-2.5% in the next decade from 3.4% in the past decade. Based on this assumption, China’s automobile annual sales will likely increase to 29-32 million units in 2030. What Are The Underlying Drivers For Such Significant Growth? First, the interest in buying a NEV is rapidly growing in China. In a September 2020 survey done by Roland Berger, 80% of surveyed potential car buyers in China were considering buying an electric vehicle as their next car, the highest among major economies (Chart 3). Last year, this surveyed number for China was only 60%. We believe this shift in buying intention will continue and will consequently translate into a boom in NEV sales during 2021-2030. NEV battery costs have decreased by nearly 90% since 2010 and will continue to fall (Chart 4). This will drive down average NEV selling prices as the battery in general accounts 40-45% of the total production cost of NEVs, thereby making them more appealing to buyers. Chart 3China: Rising Interest In NEV Purchases Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Chart 4NEV Battery Costs Will Continue To Fall NEV Battery Costs Will Continue To Fall NEV Battery Costs Will Continue To Fall The average driving range per charge for NEVs will continue to rise. The average driving mileage per charge in China has nearly doubled, from 190km in 2016 to 360km in 2019.1 Currently, a growing proportion of NEV vehicles on the market can even achieve a mileage of 600km and above with a single charge. This is already comparable to traditional gasoline-powered vehicles, which can also cover approximately 600km per fuel tank.  More models with a wide range of selling prices will soon be on the market. Last June, the cheapest electric car with a selling price of only RMB 28,800 (about US$4,000) was released into the Chinese market. Since then the sales of this model have quickly surpassed the Tesla Model 3 to become the hottest seller in China. This shows consumer enthusiasm for affordable NEVs. In the meantime, the success of Tesla electric cars in China demonstrated Chinese consumers’ strong interest in high-quality and expensive NEVs. Chart 5China Has The Most NEV Models In The World Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Chart 5 shows that China is the country with most electric vehicle models in the world. The number of available electric vehicle models  was 227 in China in 2019, significantly higher than all other individual countries. According to McKinsey, more than 250 new battery electric vehicle (BEV) and plug-in hybrid electric vehicle (PHEV) models will be introduced in the next two years alone. Most of these models will likely be sold in China, adding more purchase options for Chinese consumers. Faster charging time for EV batteries as well as expanding charging/battery-swapping networks are in the making. This will greatly reduce recharge waiting time for NEV drivers. Chart 6Chinese NEV Charging Infrastructure: The Rapid Expansion Will Continue Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Based on the data from the China Electric Vehicle Charging Infrastructure Promotion Alliance (EVCIPA), the number of both public and private charging poles has increased significantly from 2015 to 2020. In addition,  the number of private ones has already exceeded the number of public ones each year since 2017 (Chart 6). The rapid expansion in the country’s charging station network will continue. The number of total charging poles will likely rise from 1.7 million units to the government’s target of 5 million units in 2025. In addition, Wood Mackenzie last May forecasted this number could reach 9.8 million units in 2030. Roland Berger last September reported that the number of charging locations per 100 km of roadway was about 6.1 in China, significantly higher than 2.2 in Germany and 0.5 in the US (Chart 7). In terms of the number of charging stations per 1000 NEVs, China has also significantly exceeded other major automobile producing countries (Chart 8). Chart 7The Number Of Charging Locations Per 100 km Of Roadway Is Higher In China Than In Many Other Countries… Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Chart 8…The Same Is True Of The Number Of Charging Stations Per 1,000 NEVs Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Meanwhile, the Chinese government is also promoting an expansion of battery-swapping networks. The Chinese auto manufacturer Nio has been the leader in this area. The company currently has a network of 178 battery-swapping stations located in and between major cities such as Beijing and Shenzhen; by the end of the year, it plans to have 500 stations. The battery-swapping time for the Nio EV now can be as fast as 90 seconds, even faster than fueling up with gasoline. EVs will become increasingly equipped with functions such as autonomous driving and more software applications-based services. EVs will also become more integrated with intelligent and interactive networks. All these features will make EVs more attractive to automobile buyers.  Second, with the 2030 target for peak emissions, the Chinese authorities will likely continue to develop favorable polices for the domestic NEV sector. China’s key policy support tools for NEVs include tax reductions, direct subsidies to manufacturers, consumer subsidies, and mandated government procurements. In the past, China has provided immense support for NEVs by spending billions of dollars on direct subsidies to manufacturers2 and on consumer subsidy programs.3 In the future, the country’s policy focus will be on NEV charging/battery-swapping network development as well as on NEV-related technology research and investment. For example, since 2019, auto manufacturers have received credits for each NEV produced. The credits take into consideration factors such as the type of vehicle, as well as its maximum speed, energy consumption, weight, and range. This measure will encourage NEV automakers to put more emphasis on technological change. These government supports of technology and network development, coupled with strong interest in NEV purchases by domestic consumers, should offset the impact of the government’s reduced direct subsidies for NEV production and sales. China has reduced overall direct subsidies to both NEV manufacturers and consumers, and vehicles must meet minimum technical and performance criteria to qualify. In 2021, subsidies will be reduced by 20% on NEVs for personal use, and by 10% on NEVs for public transport, including buses and taxis, from their respective 2020 level. In addition, NEV subsidies and tax exemptions will expire at the end of 2022 and subsidies will be limited to 2 million NEVs per year from 2020 to 2022. A vehicle price limit for passenger cars of CNY300,000 has also been introduced. The NEV subsidy level is currently less in China than in European countries as well as in the US, showing the Chinese NEV market’s diminishing dependence on subsidies. Bottom Line: The country’s NEV production and sales will get supercharged by continuing favorable polices and by increasing consumer interest in NEVs during 2021-2030. We expect China’s NEV sales to reach 12 to 13 million units in 2030, eight to nine times its 2020 level of 1.37 million units. Growing China’s Competitiveness In The Global NEV Supply Chain The global NEV market has two main subsectors – plug-in hybrid electric vehicles (PHEV) and battery electric vehicles (BEV). The former can be operated in either the electric-powered mode or internal-combustion engines (ICE) mode. The BEVs can only run in electric mode and are also called pure electric vehicles. Traditional ICE vehicle manufacturers from Europe, US, Japan, and South Korea have more competitive advantages in the global PHEV subsector supply chain due to their long-term dominance in the global traditional ICE vehicle market. Chart 9BEVs Account For Over 80% Of Chinese NEV Sales BEVs Account For Over 80% Of Chinese NEV Sales BEVs Account For Over 80% Of Chinese NEV Sales China has been putting more focus on the new BEV market as it has enabled a level playing field with traditional ICE vehicle players. Hence, China has stronger competitiveness in the global BEV subsector. BEVs account for approximately 82% of Chinese NEV sales (Chart 9). According to China-SAE, this ratio could reach 95% by 2035 as China will increase its development of the BEV market and the adoption of BEV vehicle options.   We expect China’s competitiveness will continue to grow along the global NEV supply chain, especially in the BEV subsector. Having the largest domestic NEV market in the world gives China the advantage of attracting NEV manufacturers and building a more integrated global supply chain. During 2017-2020, accumulated world NEV sales were about 8.8 million units, with the largest share of 49% coming from China, higher than 31% for Europe and 14% for the US (Chart 10).   China is the largest NEV battery producer in the global NEV supply chain. The battery is the most important component of a NEV, and its technological progress holds the key to transitioning away from fossil fuel dependence. Data shows that six out of the world’s top ten NEV battery producers are Chinese companies, together accounting for 41% of global battery sales in kwh last year (Chart 11). Chinese company CATL has been the largest NEV battery producer for the past four years. Chart 10China Has The Largest NEV Market In The World Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Chart 11Chinese Companies: Major Players In The Global NEV Battery Market Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) The development of charging/battery-swapping infrastructure will continue to be faster in China than in other countries/regions due to the country’s much larger scale of EV users and related policy support. This allows China to collect more NEV charging-related data, which may be used to improve the country’s NEV manufacturing process, charging pole production, and the country’s charging infrastructure development.  The development of the 5G network is much more advanced in China than in any other countries. This allows NEV makers to work closely with IT/internet companies such as Huawei, Baidu, Tencent and Alibaba to test integrated applications such as the autonomous driving and AI functions of NEVs. This will help promote the technology advancement related to NEVs in all aspects in China. Chart 12Chinas NEV Net Exports Are Set To Go Up Chinas NEV Net Exports Are Set To Go Up Chinas NEV Net Exports Are Set To Go Up Due to its competitive advantages, China has become a net exporter of electric vehicles (Chart 12). In 2019, Chinese NEV sales abroad accounted for only 1.7% of the world total in US dollar terms, far below the US (31%), Germany (15%), and South Korea (9%). We expect growing competitiveness will allow China to gain share in global NEV exports. The area China needs to work on the most along the NEV supply chain is the design/manufacturing of automotive chips. There is still no Chinese company among the top ten global auto chip semiconductor companies based on sales revenue (Chart 13). Chart 13China’s Greatest Weaknesses Lie In Automotive Chip Design/Manufacturing Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Non-Chinese companies account for about 90% of the global auto chip supply while China contributes no more than 5%. The current automotive chip shortage has done much more severe damage to automakers in China than in any other country. Bloomberg recently reported the global auto industry might lose US$61 billion of 2021 sales from chip shortages, with 42% of the losses from China. In the recent National People’s Congress, the Chinese government reiterated the importance of addressing this weak link, with an urgency on reducing the country’s dependence on foreign auto chips. Bottom Line: China will become globally more competitive in the NEV supply chain. Impact On Commodity Markets The evolution in China’s NEV markets in this decade will have various impacts on commodities such as crude oil, copper, nickel, cobalt, and lithium. During 2021-2030, massive NEV adoption will only modestly reduce Chinese crude oil consumption for the transportation sector, while significant growth in NEV/charging pole/battery production will increase the country’s copper demand. Meanwhile, as NEV battery production requires raw materials including nickel, cobalt and lithium, rapid growth in NEV battery production will also have different impacts on these commodity markets.    Crude oil: In 2019, the total number of vehicles in China was 252.6 million units and the country’s total gasoline and diesel consumption was about 6,800 thousand barrels per day (kbpd) of crude oil equivalent. This equals 26.7 kbpd per 1000 vehicles. Annual NEV sales in China will rise from 1.37 million units in 2020 to about 12 million units in 2030. Assuming all these NEVs are only using their electric battery, this will cut oil consumption/imports by an increasing amount every year, ranging from 50 kbpd in 2021 to 320 kbpd in 2030. The reduction from increased NEV sales will have a relatively minuscule impact on China’s total crude oil imports. A 50-kbpd reduction in 2021 would account for less than half a percent of China’s 2020 crude oil imports. By 2030, this number could potentially rise to 1-3%, but is still insignificant. Copper: An average gasoline powered car uses only about 20kg of copper, while a hybrid car uses about 40 kg and a fully electric car uses roughly 80kg. In addition, NEV batteries and charging station chargers also require copper. Table 1 shows our rough calculation of the copper demand from the expansion of Chinese NEV market. Chinese copper demand may increase by 210 thousand tons in 2021 and by about 1,500 thousand tons in 2030. To put this into perspective, China consumed about 15 million tons of copper in 2020 based on World Bureau of Metal Statistics (WBMS) data. The increase in copper demand in 2021 is only 1.4% of 2020 copper consumption in China. However, when it increases to 1,500 thousand tons in 2030, it will account for 10% of China’s current copper consumption. Table 1China's Copper Demand Due To EV Adoption In 2021 And 2030 Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Implications Of China’s 2030 CO2 Peak Emission Target (Part II: New Energy Vehicles) Chart 14Chinas NEV Boom Will Have A More Positive Impact On Nickel And Lithium Demand Than On Cobalt Demand Chinas NEV Boom Will Have A More Positive Impact On Nickel And Lithium Demand Than On Cobalt Demand Chinas NEV Boom Will Have A More Positive Impact On Nickel And Lithium Demand Than On Cobalt Demand Nickel: The NEV battery technology is on a trend to reduce the use of cobalt given its high price and limited supply, while increasing the use of nickel. This will be a long-term positive factor for nickel prices (Chart 14, top panel). Cobalt: EV battery makers are trying to reduce or even avoid the use of cobalt. In the next couple of years, the demand for cobalt will likely remain strong as the technology of non-cobalt batteries is still in the developing stage. Non-cobalt batteries in development include solid-state , lithium-sulphur, sodium-ion and lithium-air batteries. However, cobalt prices may face increasing headwinds in the longer term (Chart 14, middle panel). Lithium: Lithium is a very abundant mineral produced from either brines or hard rock sources, with products from clays also in the pipeline. There is no structural constraint on global lithium production. Lithium prices may remain elevated in the near term but as the supply catches up over a longer run, we expect lithium prices to go down (Chart 14, bottom panel). Bottom Line: The massive growth in the Chinese NEV market in this decade will have a small negative impact on crude oil demand and a more positive impact on commodity demand such as copper, nickel, cobalt, and lithium. However, cobalt may face a substitution risk due to its elevated prices while lithium may face the risk of increasing supply. Investment Implications On NEV-related Stocks Chart 15The Chinese NEV stocks: A Good Long-term Investment, But We Recommend Waiting For A Better Entry Point The Chinese NEV stocks: A Good Long-term Investment, But We Recommend Waiting For A Better Entry Point The Chinese NEV stocks: A Good Long-term Investment, But We Recommend Waiting For A Better Entry Point We believe share prices of the Chinese NEV makers and NEV battery producers will deliver considerable positive long-term returns. The basis for this assumption is that many of them will experience strong revenue growth over this decade. While NEV maker stock prices have recently fallen considerably, we think they are still overpriced and recommend waiting for a better entry point (Chart 15).    Ellen JingYuan He     Associate Vice President ellenj@bcaresearch.com   Footnotes 1Source: “Technology Roadmap 2.0 for Energy-Saving and New Energy Vehicles,” released on October 27, 2020 by the China Society of Automotive Engineers (China-SAE). 2For example, as part of China’s 2012 “Energy-Saving and New Energy Vehicle Industry Development Plan (2012–2020),” the central government allocated over $15 billion to support the development of energy-efficient vehicles and NEVs, pilot car projects, and electric vehicle infrastructure. Source: "Chinese Government Support for New Energy Vehicles as a Trade Battleground", published by The National Bureau of Asian Research" on September 27, 2017. 3For example, the central government had provided 60,000 yuan (approximately $8,700) and 50,000 yuan (approximately $7,250) per car in subsidies for electric vehicles and plug-in hybrid vehicles, respectively, covering 40%–60% of the cost of the vehicle. Local governments also created their own subsidy programs that provided additional discounts for NEV purchases through cash subsidies, free parking, or free license plates. Source: "Chinese Government Support for New Energy Vehicles as a Trade Battleground", published by The National Bureau of Asian Research" on September 27, 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights We are lowering our expectation for oil-demand growth this year, bringing it more in line with levels expected by OPEC, the IEA and EIA.  Our GDP-driven demand estimates have proven too bullish for 1Q21, considering the wide margin by which we missed actual demand in January and February.  Our expectation for oil demand growth this year is lowered to 5.5mm b/d, down from 6.6mm b/d last month.  For 2022, we are increasing our growth assumption to 4.1mm b/d, up from 2.8mm b/d. We continue to expect Brent prices to reflect an accommodation between Russia's and KSA's preferred Brent ranges of $50-$55/bbl and $70-$75/bbl, respectively.  We are keeping our forecast for average prices at $65/bbl and $70/bbl for this year and next, with WTI averaging $2-$3/bbl below that (Chart of the Week). Brent benchmark pricing confusion subsided, following the decision of S&P Global Platts to revert to free-on-board (FOB) reporting of prices.  However, as the center of gravity for crude oil demand settles on Asia, confusion around the North Sea benchmark could provide an opening for regional benchmarks and consolidation of futures platforms trading crudes delivered to the region. Feature The decision by the Kingdom of Saudi Arabia (KSA) to voluntarily remove 1mm b/d of its production from the market over February – April will be remembered as one of the more prescient reads on the state of global oil demand during the COVID-19 pandemic. KSA's insistence on seeing improvement in actual demand – as opposed to forecasted demand – before it commits to returning production to the market could not have been more clear-sighted. The upcoming April 1 meeting of OPEC 2.0 will convey useful information to the market re changes, if any, to the production-management strategy of the coalition, which is led by KSA and Russia. Perhaps the most important information coming out of the meeting will be how KSA reads the current state of global oil demand, as it has not committed to a date-certain when it will return this production to market. We expect the Kingdom to extend its production cuts and to lobby for continued restraint by the other member states of OPEC 2.0 at the meeting. Going into the meeting, OPEC 2.0 will be assessing global demand against a deteriorating public-health backdrop in important consuming markets. The EU's policy failures in securing sufficient vaccinations to protect its population, and public-health missteps regarding the AstraZeneca vaccine continue to retard Europe's efforts to contain the pandemic.1 Chart of the WeekOPEC 2.0 Expected To Maintain Production Discipline OPEC 2.0 Expected To Maintain Production Discipline OPEC 2.0 Expected To Maintain Production Discipline Increasing lockdowns in several EU countries and a higher likelihood of a resurgence in COVID-19 infection rates in the US – particularly in the states that are reopening before they have achieved herd immunity or have vaccinated a large share their populations – will slow demand recovery. The annual Spring Break holidays in the US potentially could become a world-class super-spreader event. Elsewhere, LatAm is distressed, particularly Brazil, which, like the EU, has misjudged and mishandled its vaccination policy and rollout, leaving its populations at higher risk for infection. This also has the attendant risk of producing an environment ripe for further COVID-19 mutations and the spread of new variants. Lower Oil Demand Forecast For 2021 We were wrong on our call expecting stronger demand growth in 1Q21 – our consumption forecasts exceeded realized demand an average of 2.3mm b/d in 1Q21. We are now more aligned with demand expectations of IEA, EIA, and OPEC (Chart 2). Our expectation for oil demand growth this year is lowered to 5.5mm b/d, down from 6.6mm b/d last month. For 2022, we are increasing our growth assumption to 4.1mm b/d, up from 2.8mm b/d. We expect non-OECD oil consumption, our proxy for EM demand, to average 53.2mm b/d this year and 55.5mm b/d next year, vs. 54mm b/d and 55.4mm b/d last month. DM demand, proxied by OECD oil consumption, is expected to average 44.5mm b/d and 46.3mm b/d next year, versus our previous forecast of 44.9mm and 46.3mm b/d last month. Chart 2Lower Oil Demand In 2021, Higher Next Year Lower Oil Demand In 2021, Higher Next Year Lower Oil Demand In 2021, Higher Next Year We continue to expect the massive fiscal and monetary stimulus to support markets and lead to stronger growth going forward. The recently approved package by the US Congress calling for an additional $1.9 trillion of fiscal stimulus will have global knock-on effects, which will be bullish for commodity demand, once the COVID-19 pandemic is contained (Chart 3). Chart 3Pandemic Recovery Will Spur Pent-Up Demand OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Persists The salient feature of the oil market during the pandemic has been the cohesion of OPEC 2.0 and its production discipline. We expect that to continue going into and coming out of the coalition's April 1 meeting. Our view that OPEC 2.0 's overall strategy as the dominant producer in the market is to calibrate the level of supply to the level of demand remains intact. We expect production for the coalition to average 46.0mm b/d in 2021 and 46.2mm b/d in 2022 (Chart 4). We do not expect OPEC 2.0 to raise production, given the increasing uncertainty around demand vis-à-vis getting the COVID-19 pandemic under control in large consuming markets like the EU and LatAm, and higher infection rates out of the US. However, as we noted above, we are closely watching what KSA does and says at the upcoming meeting for any clue that global demand is improving faster than we now expect. Chart 4OPEC 2.0 Production Discipline Persists OPEC 2.0 Production Discipline Persists OPEC 2.0 Production Discipline Persists Outside OPEC 2.0, our expectation for the bellwether US shale-oil producers' output remains relatively unchanged. We continue to expect production to move higher, and to remain constrained by capital availability. US shale output is expected to average 10.7mm b/d this year, and 12.1mm b/d next year. In our modeling, the shale producers lead the price-taking cohort, which produces whatever the market allows it to produce. We continue to expect capital-market discipline to keep US oil producers from getting too far out ahead of their balance sheets' ability to profitably grow production. The same holds for producers outside the OPEC 2.0 coalition ex-US (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Still Required To Balance Markets Markets Balance On OPEC 2.0 Discipline OPEC 2.0's production strategy will keep markets balanced, as relatively high compliance among those producers capable of increasing production is observed and markets are not over-supplied (Chart 5). This will allow inventories to continue to draw then stabilize around mid-year. It is important to point out that this balancing is an iterative process, driven by OPEC 2.0's read on the state of demand, which, perforce, is occurring with lags in the data it is responding to. We continue to keep a weather eye on the USD, given the impact it has on commodity fundamentals. We continue to expect dollar weakening and model for that, but the path of the USD has been difficult to call, given it is highly correlated with global economic policy uncertainty, which is heavily influenced by the evolution of the COVID-19 pandemic (Chart 6). Chart 5Markets Remain Balanced... Markets Remain Balanced... Markets Remain Balanced... Chart 6The USD's Evolution Remains Important The USD's Evolution Remains Important The USD's Evolution Remains Important A Hue and Cry In Brent Additional uncertainty is entering oil markets from an unlikely corner: The Brent benchmark pricing index used to set prices on some two-thirds of all the oil traded in the world. Brent benchmark pricing was thrown into wide-eyed confusion when S&P Global Platts – the leading price reporting agency for the index used as a reference in Brent physical contracts (Dated Brent) – decided to convert the index from a free-on-board (FOB) index to a cost-insurance-freight (CIF) index. Platts' proposed Brent reporting changes two weeks ago essentially would have transformed the pricing index from a pure spot index that assumes the buyer will arrange insurance and freight after purchasing a cargo at a North Sea terminal into a delivered index reflecting CIF-Rotterdam terms provided by the seller. After a great hue and cry went up, Platts reverted to quoting Brent on an FOB basis. But that hardly ends the drama. Brent production is collapsing – by next year, only one 600k-barrel cargo a day of Brent will be loaded out of North Sea terminals. This is a very thin reed supporting the global oil market's primary price index. In an effort to expand the Brent pricing pool, Platts also is looking to include US WTI in one form or another, but nothing's been settled upon to date. The confusion around Brent pricing comes as the center of gravity for crude oil demand and trading continues its inexorable shift to Asia. This could provide an opening for regional benchmarks – e.g., the UAE's Murban crude oil, which supports a just-launched futures contract calling for delivery in Asia, where most of the demand for oil is met by Middle East suppliers. It could even allow for consolidation of other futures platforms in the region (e.g., the Dubai Mercantile Exchange), which also are used to price and hedge Asia-bound crude cargoes out of the Gulf. As interesting and complex as the global oil market is, it is nothing without a viable pricing benchmark. Much of the world's oil business hinges on that index being determined by the price of a single cargo loaded every day. We will be following this with great interest.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish An exceptionally cold winter resulted in a sharp drawdown US natgas inventories down, which are expected to end the 2020-21 winter season at 2021 at 1.6 Tcf by the US EIA's reckoning (Chart 7). This would be 13% lower than the 5-year average level of inventories, according to the EIA. Over the April-October injection season, EIA is expecting natgas inventories to finish at ~ 3.7 Tcf, or ~ 2% below their 5-year average. Spot natgas prices at Henry Hub, LA – the delivery point for NYMEX/CME futures – averaged $5.35/MMBtu in February, the highest level since February 2014, the EIA noted. Natural gas for April 2021 delivery at Henry Hub closed at $2.562/MMBtu on Tuesday. Base Metals: Bullish COMEX copper came close to its 2011 highs late last month, at $4.30/lb but has since retreated.  However, we believe fundamental supply-demand factors will keep copper prices moving higher over the longer term. As highlighted in an earlier report (BCA Research - Renewables, China's FYP Underpin Metals Demand), the move to EVs and renewable energy will keep demand for copper and the overall base metals complex well-bid during this decade. The International Renewable Energy Agency (World Energy Transitions Outlook: 1.5°C Pathway (Preview) (irena.org)) reported on Tuesday that copper-intensive renewable power capacity will have to increase by more than 10-fold by 2050 to avert severe climate change. On the supply side, in our recent report entitled BCA Research - Copper's Supply Challenges, we noted falling copper investment and declining copper ore quality inexorably will increase production costs. Only higher copper prices will incentivize producers to increase mining activity. Rising demand and stagnant supply will put copper supply-demand balances in a deficit over the short-to-medium term, causing inventories to decline over this period as well.  Precious Metals: Bullish The sharp run-up in 10-year US real rates since the end of 2020 pulled gold prices from down from their 2021 high of ~ $1,950/oz in January to ~ $1,680/oz earlier this month (Chart 8). Price have since rebounded above $1,740/oz as real rates weakened. We expect markets to re-price gold when it becomes apparent the rally in rates was more a function of higher growth expectations for the US economy than a higher likelihood of Fed tightening. Our view that the Fed's ultra-accommodative monetary policy and massively expansive US fiscal policy will spur growth and inflation has not changed. We expect the Fed to remain behind the inflation curve in its rate hikes, which will keep US real rates on their downward trajectory. Chart 7 OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Still Required To Balance Markets Chart 8 Gold Prices Down From Their 2021 High Gold Prices Down From Their 2021 High     Footnotes 1     Please see Extent of damage to AstraZeneca vaccine’s perceived safety in Europe revealed published by yougov.co.uk 7 March 2021.  See also States lift Covid restrictions, drop mask mandates and reopen businesses despite warnings from Biden officials published by cnbc.com 11 March 2021, and European travel restrictions: Non-essential travel curbed published by dw.com 15 March 2021. 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 Stimulus checks will not be inflationary. Most households will regard them as additional wealth, and the propensity to spend additional wealth is very low. The bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The bond market’s expectations for inflation are positively correlated with commodity prices, whereas actual prospective inflation is negatively correlated with commodity prices. When, as now, the crude oil price is above $50, long-term investors should overweight T-bonds versus Treasury Inflation Protected Securities (TIPS). The real bond yield is much higher than the bond market is pricing, which means that equities and other risk-assets are more expensive than they appear. Fractal trades shortlist: stocks versus bonds, 30-year T-bond, NOK/PLN. Feature Chart of the WeekCrude Oil Above $50 Results In Prospective Deflation Crude Oil Above $50 Results In Prospective Deflation Crude Oil Above $50 Results In Prospective Deflation Major anomalies should not exist in the financial markets, and least of all in the government bond market which is supposed to be the most efficient market of all. But a major anomaly does exist. The anomaly is in the way that the bond market prices inflation. More about that in a moment, but let’s first discuss whether the current surge in inflation expectations is warranted. The Inflationary Impact Of Stimulus Checks Is Exaggerated Inflation expectations have risen. And they have risen especially in the US, for two reasons. First, compared with Europe, the US vaccination roll-out appears to be going relatively smoothly. Second, the US government has been more pro-active in stimulating the economy, especially in the form of issuing stimulus checks to households, as well as other so-called ‘personal current transfer payments.’ Given that this has boosted incomes while spending has been constrained, the US household sector has amassed a war chest of savings. The argument goes that as social restrictions and voluntary social distancing are eased, this war chest will get spent, unleashing a tsunami of pent-up demand which will drive up inflation. But is this argument correct? Even if social restrictions do fully ease – a big if – is it correct to assume that unspent income will get spent? A recent study by the Bank of England points out that whether unspent income gets spent depends on whether households regard it as additional income or additional wealth.1 Whether unspent income gets spent depends on whether households regard it as additional income or additional wealth. The propensity to consume out of additional income is relatively high, with estimates ranging up to 50 percent. But the propensity to consume out of additional wealth is tiny, with international estimates centred around just 5 percent. This begs the question: will households regard the stimulus checks as additional income or additional wealth? The answer depends on whether the household has a low income or a high income. Lower income households, that have borne the brunt of job losses and furloughs, have suffered big drops in their income relative to consumption. Hence, they will regard the stimulus checks as additional income. But to the extent that the additional income is just (partly) replacing lost income, it will not boost their consumption versus what it would have been absent the lost income. On the other hand, higher income households and retirees have largely maintained their incomes while their consumption has fallen. This is where the surge in savings is concentrated. But not being ‘income or liquidity constrained’, these higher income households are more likely to deposit the stimulus checks into their savings accounts (or the stock market), regarding it as additional wealth. Hence, any boost to consumption will be modest and short-lived. In fact, this was precisely what happened after previous issues of stimulus checks, such as in 2008 and 2009. Stimulus checks had no meaningful impact on consumption or inflation trends (Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends A Major Anomaly In The Bond Market The recent surge in inflation expectations has moved in perfect lockstep with higher prices for commodities, especially crude oil. At first glance, this relationship seems intuitive. After all, we associate higher commodity prices with higher inflation. But on further thought, the tight positive correlation between inflation expectations and commodity price levels is counterintuitive. The first issue is basic maths. Inflation is a change in a price, so it should not move in lockstep with the level of any price. But there is a much bigger issue. Whether the commodity price is driving inflation expectations or whether inflation expectations are driving the commodity price, a higher price today will feed back into lower prospective inflation. In fact, a crude oil price above $50 has consistently predicted prospective deflation in the oil price, leading to CPI inflation underperforming its 2 percent target (Chart of the Week). The bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The important takeaway is that the bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The bond market’s expectations for inflation are positively correlated with commodity prices, but actual prospective inflation is negatively correlated with commodity prices (Chart I-3 and Chart I-4). Chart I-3The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... Chart I-4...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices ...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices ...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices This major anomaly in the bond market creates a great opportunity for long-term bond investors. When the (Brent) crude oil price is above $50, long-term investors should overweight T-bonds versus Treasury Inflation Protected Securities (TIPS). And vice-versa when crude falls below $50. With Brent now at $68, the appropriate long-term stance is to overweight T-bonds versus TIPS (Chart I-5). Chart I-5When The (Brent) Oil Price Is Above , Long-Term Investors Should Overweight T-bonds Versus TIPS When The (Brent) Oil Price Is Above $50, Long-Term Investors Should Overweight T-bonds Versus TIPS When The (Brent) Oil Price Is Above $50, Long-Term Investors Should Overweight T-bonds Versus TIPS There are also implications for other investors. Given that the bond market is useless at predicting inflation, it is also useless at assessing real interest rates. Specifically, when crude is above $50, the ex-post (realised) real bond yield will be higher than the ex-ante (assumed) real bond yield (Chart I-6). The important takeaway right now is that in any comparison with the real bond yield, equities and other risk-assets are even more expensive than they appear. Chart I-6When The (Brent) Oil Price Is Above , The Realised Real Bond Yield Will Be Higher Than Assumed When The (Brent) Oil Price Is Above $50, The Realised Real Bond Yield Will Be Higher Than Assumed When The (Brent) Oil Price Is Above $50, The Realised Real Bond Yield Will Be Higher Than Assumed Embrace The Fractal Market Hypothesis The Fractal Market Hypothesis (FMH) is a breakthrough in the understanding of financial markets, replacing the defunct Efficient Market Hypothesis (EMH). The breakthrough insight from the Fractal Market Hypothesis is that the market is not always efficient. The market is efficient only when a wide spectrum of investment time horizons is setting the price, signified by the market having a rich fractal structure. The Fractal Market Hypothesis (FMH) is a breakthrough in the understanding of financial markets. The corollary is that when the fractal structure becomes extremely fragile, it tells us that the information and interpretation of long-term investors is missing from the recent price setting, and is likely to reappear. At which point, the most recent price trend, fuelled by short-term groupthink, will break down. As most investors are unaware of the Fractal Market Hypothesis, it gives a competitive advantage to the few investors that do embrace it. Through the past five years, our proprietary Fractal Trading System has identified countertrend trading opportunities with truly excellent results. After 207 trades, the ‘win ratio’ stands at 61 percent. Yet as we understand more about this breakthrough theory of finance, we believe we can do even better. Today, we are very pleased to upgrade the trading system with innovations to the calculations of fractal structure, the countertrend profit opportunity, and the optimal holding period, all detailed in Box I-1. Box 1: Fractal Trading System Principles Countertrend opportunities in an investment will be identified by a fragile composite fractal structure, based on 65-day, 130-day, and 260-day fractal dimensions approaching their lower bounds. The countertrend profit target will be based on a Fibonacci retracement. There will be a symmetrical stop-loss. The maximum holding period will be trade-specific and vary from 33 to 130 business days (broadly 6 weeks to 6 months). From today, we will also identify a larger number of fragile fractal structures and especially highlight those that are evident in mainstream investments. From this shortlist of candidates, we will choose the most compelling to add into our portfolio. In many cases, the alignment of a fundamental argument with a fragile fractal structure will reinforce the investment case. Among our most recent recommendations, underweight China versus New Zealand achieved its 9 percent target, short Korean won versus US dollar achieved its 2.5 percent target, and long Russian rouble versus South African rand expired at 1.5 percent profit. This week, we highlight that the composite fractal structures of stocks versus bonds and the 30-year T-bond are becoming extremely fragile (Chart I-7 and Chart I-8). To be clear, this does not guarantee a countertrend move, but it does indicate an elevated susceptibility to a countertrend move. Hence, for the time being, we remain tactically neutral stocks versus bonds.  Chart I-7The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile Chart I-8The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile In the foreign exchange markets, we note that the strong advance in the Norwegian krone, fuelled by the rally in crude oil, is vulnerable to a pullback (Chart I-9). Accordingly, this week’s recommended trade is short NOK/PLN, setting a profit target and symmetrical stop at 2.6 percent. Chart I-9Short NOK/PLN NOK/PLN NOK/PLN   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Bank of England, An update on the economic outlook by Gertjan Vlieghe, 22 February 2021 Fractal Trading System A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Asset Performance A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Equity Market Performance A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations