Commodities & Energy Sector

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 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 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 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 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) 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... Chart 6The 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 Chart 8     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

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 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 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... Chart I-4...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 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 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 Chart I-8The 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   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 Structural Recommendations Closed Fractal Trades Asset Performance Equity Market Performance Indicators Bond Yields Chart II-1Euro Area Chart II-2Europe Ex Euro Area Chart II-3Asia Chart II-4Other Developed   Interest Rate Chart II-5Expectations Chart II-6Expectations Chart II-7Expectations Chart II-8Expectations  

Special Report

Highlights The miserable performance of commodities as an asset class post-GFC (since 2010) has disincentivized investment in oil and metals, which means growth in supply will lag demand going forward (Chart of the Week). Energy: Bullish. OPEC 2.0’s massive spare capacity supports its production-management strategy, and will keep crude-oil forward curves in backwardation. Base Metals: Bullish. With supply growth flat to negative year-on-year (y/y), copper and aluminium will post physical deficits as demand ex-China recovers. This will keep their forward curves backwardated as well. Precious Metals: Bullish. We expect the Fed’s ultra-accommodative policy to keep US real rates low, and return the USD to a bear market. This will be bullish for gold. Ags/Softs: Neutral. Ag markets remain balanced, punctuated by periodic weather-related rallies. A weaker USD also will be bullish for grains. In line with our expectation for stronger prices, continued backwardation in industrial commodities and a weaker USD, we are getting long the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT) at tonight’s close. This will broaden our exposure to commodities as an asset class. Risks due to COVID-19 persistence and a higher USD demand remain. The balance of risk, however, is to the upside. Feature Commodities as an asset class performed miserably post-Global Financial Crisis (GFC), as the Chart of the Week demonstrates. Partly this is due to the erratic-but-ultimately-accommodative monetary policies globally coming out of the GFC, which went into hyperdrive during the COVID-19 pandemic and supercharged demand for financial assets. During this period, industrial commodities suffered from periodic surpluses resulting from overproduction set off by high prices at the beginning of the 2000s when China set off a global commodity super-cycle. In the post-GFC world, producers brought commodities to market almost oblivious to the state of demand. This over-investment on the supply side led to market-share wars in oil and bulks like iron ore, which were ruinous to producers. Endogenous factors were not the only source of under-performance for commodities post-GFC. Stop-and-go fiscal stimulus in EM markets, which made base metals demand difficult to forecast; massive crop harvests and carry-over stocks year after year; highly erratic trade policy that distorted the flow of ags and manufactured products with out-of-the-blue tariffs, and a once-in-a-century pandemic that wiped out ~ 10% of global oil demand, all contributed to weak and volatile market conditions. Chart of the WeekCommodities As An Asset Class Performed Miserably Post-GFC Commodity producers, too, incentivized investors to seek greener pastures over this period, owing to their inability to earn returns in excess of their cost of capital, let alone anything even close to the returns available in the tech-heavy growth sector of equities markets. Producers’ difficulties have been compounded by the growing importance of ESG investing (Environmental, Social, and Governance), which, over time will increase the cost of producing commodities compliant with consumers’ and investors’ stated preferences for sustainable and equitable business practices. Investors, as is their wont, made it perfectly clear they have no interest investing in firms that cannot produce commodities profitably in line with ESG goals. There are too many opportunities elsewhere to invest in firms that can deliver goods and services profitably, regardless of how important commodities might be to the global economy. Industrial commodity markets, particularly oil and metals, now are under-resourced on the supply side, just as demand ex-China recovers in the wake of massive fiscal and monetary stimulus – with more on the way in the US. The Return Of Commodity-Index Investing For investors in long-only commodity-index instruments that provided a source of uncorrelated returns at the turn of the 21st century, the post-GFC period was long and painful. However, the balance of risks in these instruments – given the underlying fundamentals in the largest sectors of the asset class – is decidedly to the upside. Returns from long-only commodity indexes are derived from price appreciation of the index, so-called roll-yields, and the return on collateral used to post margin to support futures and exchange-cleared swaps comprising the index.1 In the industrial commodities, price gains have come from tightening markets – i.e., demand levels exceed supply levels, pushing prices higher. In oil, OPEC 2.0’s production-management strategy has been remarkably successful in reducing the supply overhang that has plagued markets on and off for the entire post-GFC period (Chart 2). Chart 2Oil Demand Will Exceed Supply Per OPEC 2.0 Strategy On the metals side, production growth has flattened in copper (Chart 3) and aluminum (Chart 4) as demand ex-China starts to recover. We expect physical deficits this year and next. Chart 3Copper's Physical Deficits Will Keep Futures Bacwardated Chart 4Flat To Backwardated Aluminum Forwards Expected In the case of copper, this will extend a two-year stretch of zero supply growth that has forced inventories to draw globally. Prices have rallied sharply on the back of these deficits, but will have to be sustained at these levels – and go higher – to spark investment in new supply necessary to support a revival of global economic growth; the buildout of renewable generation and new grids, and consumer-driven electric vehicles (EVs) demand. The only market that we are not bullish on due to tightening fundamentals is ags. While global grain and soybean inventories are falling (Chart 5), it’s a mixed picture. Global bean stocks are down (Chart 6), as are corn stocks (Chart 7). Wheat stocks are moving higher (Chart 8), while rice stocks remain roughly flat y/y (Chart 9). Chart 5Global Grain Balances Tightening Slightly Chart 6Global Bean Stocks Are Falling... Chart 7...As Are Corn's Fundamentals Chart 8Global Wheat Stocks Are Rising... Chart 9...While Rice Stocks Remain Balances Roll Yields From Industrial Commodities In addition to supply-demand fundamentals being supportive of industrial commodities’ price levels, we continue to expect a weakening of the USD, which will provide a strong tailwind to commodity price levels particularly gold, which we model primarily as a function of financial variables including the dollar and US real rates (Chart 10). A weaker USD also will be supportive of oil price levels, which have been in a long-term equilibrium with the dollar since 2000, when oil became a random-walking commodity (Chart 11).2 Metals also will get a lift from a weaker USD (Chart 12), as will ags (Chart 13), which remain balanced and well-supplied. This overall support to demand from the weaker dollar will, all else equal, put pressure on inventories and force them lower. Chart 10Weaker USD Will Boost Gold... Chart 11...Provide Oil A Tailwind... Chart 12...Lift Metals... Chart 13...And Ags This is particularly important for commodity-index investing, since falling inventories lead to backwardated forward curves, which are the principal source of roll yields in long-only index products.3 For long-only commodity index investors, the periods when commodities outperformed equities were characterized by backwardated forward curves, and, typically but not always, rising prices. Of the two factors driving commodity returns, backwardation is the most persistent and long-lived. Price increases (and decreases) often result from shocks. The market responds to a shock, finds a new level, and then oscillates randomly around it. Investment Implications We believe we are entering a period that will be characterized by tighter supply-demand balances for industrial commodities. The result of this will be lower inventories for oil and base metals, which will keep price levels well bid and forward curves flat to backwardated. A weaker USD will support industrial commodities, gold and ag prices. These are ideal conditions for long-only commodity-index investors. While there are numerous vehicles available to investors to express this view, we believe a dynamic portfolio approach – which chooses exposure for individual index components based on their backwardation – is best suited to current market conditions, given that we expect these markets to be in asynchronous bull markets over the next couple of years.4 At the close of business tonight, we will be getting long the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), in order to broaden our exposure to commodities as an asset class. This index is maintained by S&P Dow Jones Indices.5 Separately, in a housekeeping note, we were stopped out of our tactical nickel position with a loss of 15.8%, following a sudden sell-off Friday. Based on reporting from forbes.com, China’s Tsingshan Holding Group took the market by surprise with its news release that it is producing “a battery-grade form of nickel from low-grade saprolite ore, a technical breakthrough which threatens to flood the nickel market.”6 We will continue to evaluate this development vis-à-vis re-entering our tactical nickel position in the near term.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Roll yield refers to the gain from a commodity spread trade. A useful way to understand this is to imagine a market in which the forward curve is flat, i.e., the prompt futures contract for delivery next month is trading at the same price as a deferred futures contract specifying delivery in the following month. Assume an investor buys the prompt contract and the holds this position until it has to be either liquidated or rolled forward and its price has gone up, while the deferred contract’s price is unchanged. The investor can sell the prompt contract and use those proceeds to buy the deferred contract, which is still trading unchanged. The investor can either buy more of the contract with the proceeds from this trade, or invest it elsewhere. The gain from this transaction is referred to as the “roll yield.” In a backwardated market – this process can be repeated (buying at a low price and selling at a higher price as the futures contract rolls up the curve and gets closer to delivery), which is an ongoing source of yield. Of course prompt prices can fall below where the deferred contract was purchased, resulting in a loss, but typically the roll yield in a backwardated market is persistent. The opposite holds for contango market, which results in negative returns for investors buying, holding, and rolling futures seeking to earn roll yields. These spread trades are the commodity markets’ analog to the curve-steepeners and curve-flatteners in fixed income markets (e.g., the 2s-10s spread in U.S. Treasuries). 2     Please see Helyette Geman, (2007), "Mean Reversion versus Random Walk in Oil and Natural Gas Prices,“ in Advances in Mathematical Finance, Birkhäuser, Boston. 3    Please see Commodities As An Asset Class V. 3.0, a Special Report we published 21 August 2014. It is available at ces.bcaresearch.com. 4    We develop this thesis in last week’s Special Report entitled Industrial Commodities Super-Cycle Or Bull Market?, which is available at ces.bcaresearch.com. 5    Please see S&P GSCI Dynamic Roll, particularly its Methodology, which was published by S&P Global in January 2021. 6    Please see Nickel Price Falls By 16% But That Might Not Help EV Makers published by forbec.com 8 March 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades

Highlights The recent backup in bond yields could cause stocks to fall further in the near term. However, history suggests that as long as yields remain low in absolute terms, as they are now, equities will recover. Market angst that the Fed is about to turn more hawkish is unwarranted. Central banks around the world have both the tools and the inclination to keep bond yields from rising excessively. Despite the jump in bond yields, the forward earnings yield is 540 basis points above the real bond yield in the US. Outside the US, the forward earnings yield is 615 basis points above the real bond yield. In 2000, the earnings yield was below the real bond yield. Just as value stocks began to outperform growth stocks in mid-2000, the end of the pandemic will herald a similar period of value-oriented outperformance. Commodity producers and banks will lead the way. Some Parallels Between Today And 2000… Stock prices have buckled in recent weeks, raising concerns that global bourses are at risk of a major crash, just like they were in early 2000. There are certainly some notable similarities between 2000 and the present: In both cases, the preceding rise in stock prices was fueled by the Federal Reserve’s desire to prevent an exogenous shock from causing a major recession (Chart 1). Last year, the shock was the pandemic. In 1998, it was the collapse of Long-Term Capital Management (LTCM). The Connecticut-based hedge fund imploded shortly after Russia defaulted on its debt, leading to a gut-wrenching 22% decline in the S&P 500. The brewing crisis prompted the Fed to cut rates by a total of 75 basis points. Spurred on by fears of Y2K, the Fed also injected vast amounts of liquidity into the financial system. Tech stocks led the market higher both in the late 1990s and last year. The NASDAQ Composite rose 68% between its intra-day low in October 1998 and March 2000. In 2020, the NASDAQ outperformed the S&P 500 by 24% and returned 44% overall. Chart 1The NASDAQ's 1999 Surge Followed The 1998 “Insurance Cuts” And Coincided With The Fed’s Balance-Sheet Expansion Chart 2Low-Priced Stocks Have Been The Winners In The First Quarter The speculative mania in the 1990s spread from large-cap tech stocks to small-cap companies. We saw the same pattern earlier this year, with prices and trading volumes exploding among smaller, low-priced stocks (Chart 2). As was the case in the late 1990s, retail investors – this time armed with “stimmy” checks and access to zero-commission trading accounts – plowed into the market. Chart 3Some Pockets Of Bullish Equity Sentiment Chart 4Some Pockets Of Bullish Equity Sentiment Bullish equity investor sentiment was rampant at the peak of the stock market in 2000. Although not quite to the same extent as back then, most measures of investor sentiment turned bullish prior to the recent selloff (Chart 3). Like most investors, analysts were wildly optimistic on stocks in the late 1990s (Chart 4). Long-term earnings growth projections are very optimistic today, a potentially ominous signal given that (unlike in the late 1990s), productivity growth is now more anemic. Rising stock prices in the late 1990s allowed corporate insiders to cash in their options, while enabling new companies to go public. Recently, we have seen a flurry of companies list their shares, in some cases through dubious SPAC vehicles (Chart 5). Valuations reached nosebleed levels in 2000. While the forward P/E ratio on the S&P 500 is somewhat below its 2000 peak, other valuation measures such as price-to-sales, Tobin’s Q, and enterprise value-to-EBITDA are above where they were in 2000 (Chart 6). Chart 5Renewed Interest In Listing Stocks Chart 6Stretched Valuations, Then And Now … But One Important Difference Despite the parallels between today and 2000, there is an important difference: The Federal Reserve. Having cut rates in 1998, the Fed reversed course in mid-1999, eventually taking the fed funds rate up to 6.5% in May 2000. The yield curve inverted in February of that year, shortly after the 10-year yield reached a high of 6.79%. Chart 7What Happens To Equities When Treasury Yields Rise? Bond yields have risen briskly over the past six months. However, they remain very low in absolute terms. While rising yields can produce a temporary stock market correction, they need to move into restrictive territory in order to trigger a recession and an accompanying bear market in equities. Chart 7 highlights some research that Garry Evans and BCA’s Global Asset Allocation team recently produced. It shows eight episodes since 1990 of a sharp rise in the 10-year Treasury yield. On every occasion (except in 1993-94, when the Fed unexpectedly raised rates in February 1994), equities performed strongly while rates were rising (Table 1). Today, the forward earnings yield on the S&P 500 is 540 basis points above the real yield. In 2000, the real bond yield was higher than the earnings yield (Chart 8). The gap between earnings yields and real bond yields is even greater outside the US, where valuations are generally more attractive. 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 21% in real terms for equities to underperform bonds. Many other stock markets would have to decline by more than that (Chart 9). Table 1As Long As Bond Yields Don't Rise Into Restrictive Territory, Stocks Will Recover Chart 8Relative To Bonds, Stocks Are More Favorably Valued Now Than in 2000 Chart 9Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Central Banks Will Lean Against Rising Bond Yields Stocks sold off earlier today on the perception that Jay Powell had failed to push back forcefully against the recent increase in bond yields. We think this angst is unwarranted. As Powell noted, most of the rise in bond yields reflected economic optimism. If yields were to continue rising in the absence of further economic improvements, the Fed would dial up the rhetoric, stressing its ability to buy bonds in unlimited quantities in order to support the economy. Despite all the fiscal stimulus, the unemployment rate remains elevated – perhaps as high as 10% according to some Fed measures. The prime-age employment-to-population ratio is four percentage points below where it was before the pandemic (Chart 10). Moreover, many stimulus measures will expire towards the end of the year. With the prospect of a “fiscal cliff” in 2022, we expect the Fed to want to tread carefully in withdrawing monetary support. What would really rattle investors is if long-term inflation expectations were to rise above the Fed’s comfort zone. However, considering the 5-year/5-year forward inflation breakevens are still below where they were in 2012-13, this is not an imminent risk (Chart 11). Chart 10The Fed Will Remain Accommodative To Aid The Labor Market Recovery Chart 11Inflation Expectations Have Recovered But Are Still Low Like the Fed, the ECB wants to keep financial conditions highly accommodative. On Tuesday, ECB Executive Board member Fabio Panetta, echoing comments made by other senior ECB officials, said that higher yields were “unwelcome and must be resisted.” He noted that “We are already seeing undesirable contagion from rising US yields into the euro area yield curve,” adding that the ECB “should not hesitate” to increase the pace of bond purchases. The ECB’s threat is credible. Already, its purchases have deviated significantly from its capital key, revealing Frankfurt’s willingness to act where and when it is needed. In the same spirit, the Reserve Bank of Australia boosted its government bond purchases earlier this week after the 10-year yield backed up from 0.7% last October to over 1.9% late last week. The RBA also reaffirmed its intent to maintain the current 3-year Yield Curve Control target at 0.1%, stating that “The Board will not increase the cash rate until actual inflation is sustainably within the 2-to-3 percent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.” The RBA’s determination to keep bond yields down is noteworthy given that the neutral rate of interest is higher in Australia than in most other developed economies.1  If the RBA does not intend to raise rates for the next three years, it may take even longer for other central banks to take away the punch bowl. Will Value Stocks Begin To Outperform As They Did Starting In Mid-2000? There is another potential parallel with 2000 that is worth mentioning. This was the year that the outperformance of growth stocks came to a halt and value stocks began to shine. In fact, outside of the tech sector, the S&P 500 did not peak until May 2001 (Chart 12). Value continued to outperform right through to 2007. Since February 12th of this year, the price of the highly liquid Vanguard Growth ETF (VUG, market cap of $143 billion) has fallen by 8.9% while the price of the Vanguard Value ETF (VTV, market cap of $97 billion) has risen 0.5%. Despite the nascent outperformance of value names, they still remain relatively cheap. According to a simple valuation measure that combines price-to-earnings, price-to-book, and dividend yields, value stocks are more than three standard deviations cheap relative to growth stocks – a bigger valuation gap than seen at the height of the dotcom bubble (Chart 13). Chart 12The Non-Tech Portion Of The Stock Market Peaked More Than A Year After The Tech Bubble Burst Chart 13The Tech Bust Of 2000 Also Marked The Start Of A Multi-Year Outperformance By Value The Outlook For Commodity Stocks And Bank Shares Commodity producers are overrepresented in value indices. Strong global growth against a backdrop of tight supply should heat up the commodity complex over the next 12-to-18 months. Chart 14 shows that capital investment in the oil and gas sector has fallen by more than 50% since 2014. BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects crude oil demand to outstrip supply over the remainder of this year (Chart 15). Chart 14Oil + Gas Capex Collapses In COVID-19’s Wake Chart 15Crude Oil Demand 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 (Charts 16A & 16B). 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, a big slug of demand in a market that consumes about 26mm tonnes per year. Chart 16ACopper Will Be In Physical Deficit... Chart 16B...As Will Aluminum Ongoing strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger 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 17). 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. Chart 17China Keeps Buying More And More Commodities Chart 18Credit Growth Has Been Recovering Along with commodity producers, financials helped propel value indices during the 2000s. While credit growth is unlikely to revert to its pre-GFC days, it has been trending higher in both the US and Europe (Chart 18).   Analysts are starting to take note of improving bank earnings prospects. EPS estimates for banks are rising more quickly than for tech companies on both sides of the Atlantic (Chart 19). Not only is the “E” in the P/E ratio for banks likely to rise, the ratio itself will increase. Currently, US and European banks are trading at 14 and 10-times forward earnings, respectively, a huge discount to the broad market in general, and tech stocks in particular (Chart 20).  Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (I) Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (II) Chart 20Banks Are Cheap   Bottom Line: Despite near-term uncertainty, investors should overweight stocks on a 12-month horizon, while pivoting away from last year’s winners (growth stocks) towards last year’s losers (value stocks).   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  According to RBA’s estimates, the neutral rate of interest in Australia is at the high end of developed market estimates. Specifically, Australia’s R-star is higher than the average of the US and euro area R-stars and is slightly lower than the average of the Canadian and UK neutral rates. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered.  Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020.  The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed.  Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar.  Therefore, a market reset is also positive for the yen.     Housekeeping Chart I-5Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January.   The DXY index rose by 165 bps this week.  The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3%  quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on  procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion  in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights The Biden administration will not attempt a major diplomatic “reset” with Russia. The era of engagement is over. Russia faces rising domestic political risk and rising geopolitical risk at the same time. A war in the Baltics is possible but unlikely. Putin has benefited from taking calculated risks and wants to keep the US and Europe divided. The Russian economy is weighed down by structural flaws as well as tight policy. Investors focused on absolute returns should sell Russian assets. For EM-dedicated investors, our Emerging Markets Strategy recommends a neutral allocation to Russian stocks and local currency bonds and an overweight allocation to US dollar-denominated sovereign and corporate debt. Feature “We will not hesitate to raise the cost on Russia.” – US President Joseph R. Biden, State Department, February 4, 2021 The Biden presidency will differ from its predecessors in that there will not be a major attempt to engage Russia at the outset. Previous US presidents sought to reach out to their Russian counterparts to create room for maneuver. This was true of Presidents Reagan, Clinton, Bush, Obama, and Trump. Even Biden has shown a semblance of reengagement by extending an arms reduction pact. But investors should not be misled. The United States and the Democratic Party have shifted their approach to Russia since the failure of the diplomatic “reset” that occurred in 2009-11 and Washington will take a fundamentally more hawkish approach. Russia is not Biden’s top foreign policy focus – that would be Iran and China. But as with China, engagement has given way to Great Power struggle and hence there will not be a grace period before geopolitical tensions re-escalate. Tensions will keep the risk premium elevated for Russia’s currency and assets. The same is true of emerging European markets that get caught up in any US-Russia conflicts. Putin, Biden, And Grand Strategy Understanding US-Russia relations in 2021 requires a brief outline of both the permanent and temporary strategies of the United States and Russia. Russia’s grand strategy over the centuries has focused on establishing a dominant central government, controlling as large of a frontier as possible, and maintaining a high degree of technological sophistication. The nightmare of the Russian elite consists of foreign powers manipulating and weaponizing the country’s extremely diverse peoples and territories against it, reducing the world’s largest nation-state to its historical origin as a geographically indefensible and technologically backward principality. Chart 1Russia's Revival In Perspective Russia can endure long stretches of austerity in order to undermine and outlast rival states in this effort to achieve defensible borders. Russia’s strategy since the rise of President Vladimir Putin has focused on rebuilding the state and military after the collapse of the Soviet Union so as to restore internal security and re-establish political dominance in the former Soviet space (Chart 1). Partial invasions of Georgia and Ukraine and a military buildup along the border with the Baltic states show Russia’s commitment to prevent American or US-allied control of strategic buffer spaces. Expansion of the North Atlantic Treaty Organization (NATO) and the European Union poses an enduring threat to Putin’s strategy. Putin has countered through conventional and nuclear deterrence as well as the use of “hybrid warfare,” trade embargoes, cyberattacks, and disinformation. To preempt challengers within the former Soviet space Russia also maintains a “veto” over geopolitical developments outside that space, as with nuclear proliferation (Iran), civil wars (Syria, Libya), or resource production (OPEC 2.0). The evident flaw in Putin’s strategy is the decay of the economy, the long depreciation of the ruble, and the drop in quality of life and labor force growth. See the macro sections below for a full discussion of these negative trends. Compare the American strategy: America’s grand strategy is to control North America, dominate the oceans, prevent the rise of regional empires, and maintain the leading position in technology and talent. A nightmare for American policymakers would be a collapse of the federal union among the disparate regions and the rise of a secure foreign empire that could supplant the US’s naval preponderance. This is especially true if the rival empire were capable of supplanting US supremacy in technology, since then the US would not even be safe within North America. America’s strategy under the Biden administration is to mitigate internal political divisions through economic growth, maintain its global posture by refurbishing alliances, and reassert its technological primacy by encouraging immigration and trade. The status quo of strong growth and rising polarization has been beneficial for US technology but not for foreign and defense policy (Chart 2). Political polarization has prevented the US from executing a steady long-term strategy for over 30 years. As a result, Russia has partially rebuilt the Soviet sphere of influence and China is constructing a sphere of its own. A few conclusions can be drawn from the above. First, China poses a greater challenge to the US than Russia from a strategic point of view. China is capable of creating a regional empire that can one day challenge the US for technological leadership. Modern Russia must summon all its strength to carve out small pieces of its former empire – it is not a contender for supremacy in technology or in any regions other than its own. Second, however, Russia’s resurgence under Putin poses a secondary challenge to American grand strategy. Russia can undermine US strategy very effectively. The effect today is to aid the rise of China, on which Russia’s economy increasingly depends (Chart 3). Chart 2US Tech Boom Coincided With Disinflation, Polarization Chart 3Russia’s Turn To The Far East Unlike the US, Russian leadership has not changed over the past year – and Vladimir Putin’s tactics are likely to be consistent. These were underscored by the constitutional revisions approved by popular vote in September 2020. Not only will Putin be eligible to remain president till 2036 but also Russia reaffirmed its willingness to intervene militarily into neighboring regions by asserting its right to defend Russian-speaking peoples everywhere. Finally, Russia ensured there would be no giving away of territories, thus ruling out a solution on Ukraine over Crimea.1 Bottom Line: The US-Russia conflict will continue under the Biden administration, even though Biden’s primary concern will be China. Biden’s Foreign Policy Intentions It is too soon to draw conclusions about Biden’s foreign policy “doctrine” as he has not yet faced any major challenges or taken any major actions. Biden’s first two foreign policy speeches and interim national security strategy guidance establish his foreign policy intentions, which will have to be measured against his administration’s capabilities.2 His chief intentions are to revive the economy and court US allies: First, Biden asserts that every foreign action will be taken with US working families in mind, co-opting Trump’s populism and emphasizing that US international strength rests on internal unity which flows from a strong economy. This goal will largely be met as the administration is already passing a major economic stimulus and is likely to pass a second bill with long-term investments by October. The impact on Russia is mixed but the Biden administration is largely correct that a strong recovery in the US economy and reduction in political polarization will be a major asset in its dealings with Russia and other rivals. Second, Biden asserts that diplomacy will be the essence of his foreign policy. He aims to create or rebuild an alliance of democracies that spans from the UK and European Union to the East Asian democracies. The two goals of economy and diplomacy are connected because Biden envisions the democracies working together to make “historic investments” in technology, setting global standards and rules of trade, and defending against hacking and intellectual property theft. This goal will have mixed success: the EU and US will manage their own trade tensions reasonably well but they will disagree on how to handle Russia and especially China. Biden explicitly sets up this alliance of democracies against autocracies. He calls China the US’s “most serious competitor” but also highlights Russia: “The challenges with Russia may be different than the ones with China, but they’re just as real.”3 Table 1 shows the Biden administration’s notable comments and actions on Russia so far. What is clear is that the US will not seek an extensive new diplomatic engagement with Russia.4 The failure of the Obama administration’s “diplomatic reset” with Russia has disabused the Democratic Party of the notion that strategic patience and outreach are the right approaches to Putin’s regime. The reset and its failure are described in detail in Box 1. Table 1Biden Administration's First 100 Days: Key Statements And Actions On Russia Box 1: What Was The US-Russia Diplomatic Reset? What Comes Next? Most American presidents open their foreign policy with overtures to Russia to create space to maneuver, given that Russia is capable of undermining US aims in so many areas. The Barack Obama administration made a notable effort at this in 2009, which was dubbed the “diplomatic reset.” It was a rest because relations had collapsed over Russia’s use of natural gas pipelines as a weapon against Ukraine and especially its invasion of Georgia in 2008. Then Vice President Joe Biden led the reset. President Putin had stepped aside in accordance with constitutional term limits, putting his protégé Dmitri Medvedev in the presidential seat, which supported the reset because Medvedev had at least some desire to reform Russia’s economy. The reset lasted long enough for Washington and Moscow to agree on the need for a strategic settlement on the question of Iran – which would culminate in the 2015 nuclear deal – as well as to admit Russia to the World Trade Organization (WTO). But the aftermath of the financial crisis proved an inauspicious time for a reset. Along with the Arab Spring, popular unrest emerged in Moscow in 2011 and western influence crept into Ukraine – all of it allegedly fomented by Washington. Putin feared he would lose central control at home and frontier control abroad. He also sensed an opportunity given that commodity prices were filling state coffers while the US was focused on domestic policy, increasingly polarized, and unwilling to make the sacrifices necessary to solidify its influence in eastern Europe. Russia’s betrayal of the reset resulted in a string of losses for the US and its European allies: the Edward Snowden affair, the invasion of Ukraine, the intervention in Syria, the meddling in the 2016 US election, and most recently the SolarWinds hack. The Obama administration refrained from a strong reaction over Crimea partly to seal the Iran deal. But Russia pressed its advantage after that. It is doubtful that Russia’s influence decided the 2016 election but, regardless, the Democratic Party fell from power and then watched in dismay as the Trump administration revoked the Iran deal. Now that the Democrats are back in power they will seek to retaliate not only for the SolarWinds hack but also for the betrayal of the reset. However, retaliation will come at a time of Washington’s choosing. Bottom Line: The Biden administration’s foreign policy will emphasize alliances of democracies in opposition to autocracies like Russia and China. Biden is planning a more hawkish approach to Russia than previous recent administrations. Biden’s Foreign Policy Capabilities There are a few clear limitations on Biden’s foreign policy goals. First, his administration will largely be focused on domestic priorities. In foreign affairs there is at best the chance to salvage the Obama administration’s foreign policy legacy. Second, Biden’s dealings with China will take up most of his time and energy. China’s fourteenth five-year plan contains a state-driven technological Great Leap Forward that will frustrate any attempt by Biden to reduce tensions. Biden will not be able to devote much attention to Russia if he pursues China with the attention it deserves, i.e. to secure US interests yet avoid a war.5 Third, Biden will be limited by allied risk aversion and the need for consensus on difficult decisions. If his diplomacy with Europe is successful then China and Russia will face steeper costs for any provocative actions. If it fails then European risk aversion will prevail, the allies will remain divided, and China and Russia will faces few costs for maintaining current policies. Table 2Russia’s Pipeline Export Capacity The Nordstream Two pipeline will be a key test of European willingness to follow the US’s lead even if it means taking on greater risks: Nordstream Two is a major expansion of Russian-EU energy cooperation but contrary to America’s national interest. German Chancellor Angela Merkel still backs the project despite Russia’s poisoning and imprisonment of dissident Alexei Navalny and forceful suppression of protests. However, Merkel is a lame duck and there is some evidence that German commitment to the project is fraying.6 Biden has not tried to halt the pipeline project, but he still could. There are only 100 miles left to the pipeline. Construction resumed in January after a hiatus last year due to US sanctions. The project will take five months to complete at the rate of 0.6 miles per day. The Biden administration still has time to halt the project through sanctions. If it does, the Russians will react harshly to this significant loss of economic and strategic influence over Europe (Table 2). Biden will have a crisis on his hands in Europe. If Biden does nothing on Nordstream, then Russia will conclude that his administration is not serious and take actions that undermine the Biden administration in accordance with Putin’s established strategy. This would prompt Biden to act on his pledge to stand up to Putin’s provocations. Whereas if Biden imposes sanctions to halt Nordstream, Russia will retaliate. Elsewhere it is possible that Biden will be too confrontational with Russia for Europe’s liking. Biden plans to increase support for Ukraine, which will prompt an increase in military conflict this spring.7 The US will promote democracy across eastern Europe, including Belarus, and it is possible that Russia could overreact to this threat of turning peripheral regimes against Russia. The EU is on the front lines in the conflict with Russia and will not want the US to act aggressively – but the US is specifically seeking to “raise the cost” on Russia for its aggression.8 Bottom Line: Russia is not Biden’s priority. But his pledge both to promote democracy and retaliate against Russian provocations sets the US up for a period of higher tensions. US-Russia Engagement On Iran? Will the US not need to engage Russia to achieve various policy goals? Specifically, while highlighting competition, Biden says he will engage Russia and China on global challenges, namely the pandemic, climate change, cybersecurity, and nuclear proliferation. Nuclear proliferation is the only one of these areas where US-Russia cooperation might matter. After all, there is zero chance of cybersecurity cooperation. Whereas on nuclear issues, the US and Russia immediately extended the New START arms reduction treaty through 2026 and could also work together on Iran. Biden is determined to restore the Obama administration’s 2015 nuclear deal. Moscow does not have an interest in a nuclear-armed Iran so there is some overlap of interest. The Iranian issue will require Biden to consider whether he is willing to make major concessions to Russia: Compromise the hard line on Russia: A new Iranian administration takes office in August. Biden is likely to have to rush a return to the 2015 nuclear deal before that time if he wants a deal with Iran. Otherwise it would take years for Biden and the Europeans to reconstitute the P5+1 coalition with Russia and China and negotiate an entirely new deal. Biden would have to make major concessions to Russia and China. His stand against autocracy would be compromised from the get-go. Maintain the hard line on Russia: The alternative is for Biden to rejoin the 2015 nuclear deal with a flick of his wrist, with Iranian President Hassan Rouhani signing off by August. Biden would extract promises from the Iranians to keep talking about a broader deal in future. In this case Biden would not need to give the Russians or Chinese any new concessions. Chart 4China Enforces Iran Sanctions The Biden administration will be keen to make sure that Russia does not exploit the US eagerness for a deal with Iran as it did with the original deal in 2014-15. Iran has an individual interest in restoring the deal, which is to gain sanction relief and avoid air strikes. The Europeans have helped Iran keep the deal alive. China is at least officially enforcing sanctions (Chart 4). Russia is also urging a return to the deal and would be isolated if it tried to sabotage the deal. This could happen but it would escalate the conflict between the US and Russia. Otherwise, if a deal is agreed, the US will continue putting pressure on Russia in other areas. Bottom Line: The Biden administration is likely to seal an Iranian nuclear deal without any major concessions to Russia. Tail Risk – A War In The Baltics? It is well established that the Putin regime will use belligerent foreign adventures to distract from domestic woes. Just look at poor opinion polling tends to precede major foreign invasions (Chart 5). With the eruption of social unrest in the wake of COVID-19 and the imprisonment of opposition leader Alexei Navalny, it is entirely possible that Russia will activate this tool again. The implication is a new crisis in Ukraine, a larger Russian military presence in Belarus, or further escalation of hybrid warfare or cyberwar in other areas. What about an invasion of the Baltic states of Latvia, Lithuania, and Estonia? Unlike other hotspots in Russia's periphery this is a perennial "black swan" risk that would equate with a geopolitical earthquake in Europe. A Baltic war is conceivable based on Russia’s geographic proximity, military superiority, and military buildup on the border and in the Kaliningrad exclave. The combined military spending of NATO dwarfs that of Russia but NATO is extremely vulnerable in this far eastern flank (Chart 6). However, Europe would cutoff Russia’s economy and join the US in countermeasures while Russia would be left to occupy hostile countries.9 Chart 5Putin Lashes Out When Popularity Falls The Baltic states are members of NATO and thus an attack on one is theoretically an attack on all. President Trump ultimately endorsed Article V of the NATO treaty on collective self-defense and President Biden has enthusiastically reaffirmed it. The guarantee is meaningless without greater military support to enforce it, so NATO could try to reinforce its forward presence there. This could provoke Russia to retaliate, likely with measures short of full-scale war. Chart 6Russia Would Be Desperate To Invade Baltics Since the wars in Iraq and Afghanistan, US rivals have observed that the American public lacks the willingness to fight small wars. It responded weakly to Russia’s invasion of Crimea and China’s encroachments in the South China Sea and Hong Kong. However, foreign rivals do not know whether the unpredictable US leadership and public are willing to fight a major war. Hence Russia and China are likely to continue to focus on incremental gains and calculated risks rather than frontal challenges. Based on the Biden administration’s moderate political capital (very narrow electoral and legislative control), the US will continue to be divided and distracted. Russia, China, and other powers will test the administration and make an assessment before they attempt any major foreign adventures. The testing period is imminent, however, and thus holds out negative surprises for investors. It is also possible that Biden could make the first move – particularly on Russia, where retaliation for the 2020 SolarWinds hack should be expected. Bottom Line: A full-scale war in the Baltics is possible but unlikely as the Russians have succeeded through calculated risks whereas they face drastic limitations in a major war against the NATO alliance. Growth Weighed Down By Tight Policy We now turn to Russia’s domestic economic conditions. Here, Russia also faces major challenges. Authorities are determined to keep a tight lid on both monetary and fiscal policies. In particular, high domestic borrowing costs and negative fiscal thrust will weigh down domestic demand over the next six-to-12 months. There are three reasons authorities will maintain tight monetary and fiscal policies: First, concerns about high inflation are deeply entrenched among consumers, enterprises, and policymakers. Russian consumers and businesses tend to have higher-than-realized inflation expectations. This is due to the history of high inflation as well as stagflation in Russia. A recent consumer poll reveals that rising prices are the number one concern among households (Table 3). Remarkably, the poll was conducted in August amid the height of the pandemic and high unemployment. This suggests that households do not associate growth slumps with lower inflation but rather fear inflation even amid a major recession (i.e., worry about stagflation). Table 3Fear Of Inflation Prevalent Amongst Consumers’ Expectations Second, Central Bank of Russia Governor Elvira Nabiullina is one of the most hawkish central bankers in the world. Her early tenure was characterized by the 2014-15 currency crisis and a major inflation spike. To combat structural inflation and bring down persisting high inflation expectations, the central bank has adopted a very hawkish policy stance since 2014. There is no sign that the central bank is about to change its hawkish policy. Specifically, monetary authorities have been syphoning liquidity from the banking system. With relatively tight banking system liquidity and high borrowing costs, private credit growth will fail to accelerate from current levels. Third, the government still projects an austere budget for 2021. The fiscal thrust will be -1.7% of GDP this year (Chart 7). While a moderate spending increase is likely, it will not be sufficient to boost materially domestic demand. There are no signs yet that the fiscal rule10 will be further relaxed, potentially releasing more funds for the government to spend this year. The fiscal rule has become an important gauge of the country’s ability to weather swings in energy prices. In addition to the points listed above, policymakers’ inflation worries stem from the economy’s structural drawbacks: Despite substantial nominal currency depreciation in recent years, Russia runs a current account deficit excluding energy. When a country runs a chronic current account deficit, including periods of major domestic demand recessions and currency devaluations, it is a symptom of a lack of productivity gains. Real incomes grew at a quick pace from the mid-1990s, largely driven by the resource boom in the 2000s. Yet rising real incomes were not complemented by expanding domestic manufacturing capacity to produce consumer and industrial goods. As such, imports of consumer goods and services rose alongside real incomes. Russia has been underinvesting. Gross fixed capital formation excluding resources industries and residential construction has never surpassed 10% of GDP in either nominal or real terms (Chart 8). Chart 7Russia: Fiscal Policy Will Remain Austere In 2021 Chart 8Russia: Underinvestment Within Domestic Sectors Geopolitical tensions with the West have discouraged FDI inflows and hindered Russian companies’ ability to raise capital externally. This has inhibited capital spending and ”know-how” transfer and, hence, bodes ill for productivity gains. Russian domestic industries are highly concentrated and, in some cases, oligopolistic in nature. This allows incumbents to raise prices. The number of registered private enterprises has fallen below early 2000s levels (Chart 9). Despite chronic currency depreciation, Russian resource companies have failed to grab a large share of their respective export markets. For instance, Russia’s oil market share of total global oil production has been flat for over a decade and the nation has been losing market share in the global natural gas industry. A shrinking labor force due to poor demographics and meager immigration complements Russia’s sluggish productivity growth and caps its potential GDP growth (Chart 10). Chart 9Russia: Increasing Industry Concentration Some positive signs are appearing in the form of import substitution. Since the Ukraine conflict in 2014 and the resulting Western sanctions, the government has enacted various laws and decrees to incentivize domestic production, and with it providing substitutions for imported goods. Their impact is noticeable in certain sectors. Chart 10Russia: Poor Potential Growth Outlook In particular, the country has invested heavily in the food industry, as food imports are 16% of overall imports. Agricultural sector output has been rising while imports of key food categories have declined. Recent decrees on industrial goods will likely boost domestic production of some goods and processed resources. Around 40% of Russian imports are concentrated in machinery, industrial equipment, transportation parts, and vehicles. Hence, raising competitiveness in production of industrial goods is essential for Russia to reduce reliance on imports. In short, fewer imports of goods for domestic consumption will make inflation less sensitive to fluctuations in the exchange rate. The current trend is mildly positive, but its pace remains slow. Bottom Line: Russia needs to raise its productivity and labor force growth and, hence, potential GDP growth to deliver reasonable high-income growth without raising inflation. The Cyclical OutLook: Worry About Growth, Not Inflation Cyclically, high domestic borrowing costs and lackluster fiscal spending will weigh down domestic growth and cap inflation for the next 12 months. Russia’s real borrowing costs are among the highest in the EM space. High borrowing costs are causing notable financial stress amongst corporate and household debtors. Commercial banks’ NPLs and provisions are high and rising (Chart 11). Unwilling to take on more credit risk, banks have shunned traditional lending and have instead expanded their assets into financial securities. This trend will likely persist and corporate and consumer credit will fail to boost investment and consumption. The recent pickup in inflation was primarily due to rising food prices and the previous currency depreciation pass-through. Chart 12 illustrates the recent currency appreciation heralds a rollover in core inflation. Chart 11Russia: High Borrowing Costs Are Leading To Higher Credit Stress Chart 12Russia: Inflation Will Rollover Due To Stable RUB In fact, a broad range of inflation indicators suggest that core inflation remains within the central bank target (Chart 13). These measures of inflation are less correlated with the ruble movements. Chart 13Russia: Inflation Is At Central Bank Target Of 4% Chart 14Russia: Tame Recovery In Domestic Activity High-frequency data suggest that consumer spending and business activity remain tame (Chart 14). Bottom Line: The latest uptick in Russia’s core CPI is likely transitory. Cyclical conditions for a material rise in inflation and hence monetary tightening are not in place. Investment Takeaways Chart 15Russia Underperforms Amid Commodity Bull Run Russia’s sluggish economy and austere policy backdrop suggest that the fires of domestic political unrest will continue to burn. While political instability may force the Kremlin to ease fiscal policy, the easing so far envisioned is slight. The implication is that Russia faces rising domestic political risk simultaneously with the rise in international, geopolitical risk stemming from the Biden administration’s efforts to promote democracy in Russia’s periphery and push back against its regional and global attempts to undermine the US-led global order. So far the totality of Russia’s risks have outweighed the benefits of the global economic recovery as Russian assets are trailing the rally in commodity prices (Chart 15). The ruble is above the lows reached at the height of the Ukraine crisis, whether compared to the GBP or the EUR, suggesting further downside when US-Russia tensions spike (Chart 16). The currency is neither cheap nor expensive at present (Chart 17). Chart 16Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Chart 17Russia: The Ruble Is Fairly Valued   Chart 18Geopolitical Risk Will Revive Despite Apparent Top Our Geopolitical Risk Indicator for Russia is forming a bottom, implying that global investors believe the worst has passed. This is a mistake and we expect the indicator to change course and price in new risk. The result will weigh on Russian equities, which are fairly well correlated with this indicator (Chart 18). Overall, we recommend investors who care about absolute returns to sell Russian assets. For dedicated EM equity as well as EM local currency bond portfolios, BCA's Emerging Markets Strategy recommends a neutral stance on Russia (Chart 19). Rising bond yields in the US will continue weighing especially on high-flying growth stocks. The low market-cap weight of technology/growth stocks in the Russian bourse makes the latter less vulnerable to rising global bond yields. Concerning local rates, we see value in 10-year swap rates, as tight monetary and fiscal policies will keep a lid on inflation. With the central bank unlikely to hike rates anytime soon, a steep yield curve offers good value in the long end of the curve for fixed income investors. Finally, orthodox macro policies will benefit fixed-income investors on the margin. In regard to EM credit (USD bonds) portfolio, the Emerging Markets Strategy team recommends overweighting Russia (Chart 20). The government has little local currency debt and minimal US dollar debt. Not surprisingly, Russia has been a low-beta credit market and it will outperform its EM peers in a broad sell off. Chart 19Russia: Move To Neutral Local Currency Bond Allocation Lastly, the Emerging Markets Strategy is moving Ukrainian local currency government bonds to underweight and closing the 5-year local currency bond position. Risks of military confrontation on the Ukraine front have escalated. Chart 20Russia: Remain Overweight On USD Credit     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Andrija Vesic Associate Editor Emerging Markets Strategy AndrijaV@bcaresearch.com   Footnotes 1 See Pavlo Limkin et al, “Putin’s new constitution spells out modern Russia’s imperial ambitions,” Atlantic Council, September 10, 2020, atlanticcouncil.org. 2 See White House, “Remarks by President Biden on America’s Place in the World,” February 4, 2021, and “Remarks by President Biden at the 2021 Virtual Munich Security Conference,” February 19, 2021, whitehouse.org. 3 See “Remarks … at the … Munich Security Conference” in footnote 2 above. 4 We first outlined this US-Russia disengagement in our last joint special report on Russia, “US-Russia: No Reverse Kissinger (Yet),” July 3, 2020, bcaresearch.com. 5 See Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Jamestown Foundation, February 1, 2021, Jamestown.org. 6 Biden’s “Interim National Security Strategic Guidance,” White House, March 3, 2021, whitehouse.org, reinforces this point by focusing most of its attention on China and largely neglecting Russia. 7 See “Kremlin concerned about rising tensions in Donbass,” Tass, March 4, 2021, tass.com. 8 One way in which this could transpire would be a carbon border tax. The EU says imposing a tariff on carbon-intensive imports will proceed unilaterally if there is not a UN agreement in November because it is a “matter of survival” for its industry as it raises green regulation. The Biden administration also promised in its campaign to levy a “carbon adjustment fee.” Russia, which is exposed as a fossil fuel exporter that does not have a carbon pricing scheme, says such a fee would go against WTO rules. See Kate Abnett, “EU sees carbon border levy as ‘matter of survival’ for industry,” Reuters, January 18, 2021, reuters.com; Sam Morgan, “Moscow cries foul over EU’s planned carbon border tax,” Euractiv, July 27, 2020, euractiv.com. 9 See Heinrich Brauss and Dr. András Rácz, “Russia’s Strategic Interests and Actions in the Baltic Region,” German Council on Foreign Relations, DGAP Report, January 7, 2021, dgap.org; Christopher S. Chivvis et al, “NATO’s Northeastern Flank: Emerging Opportunities for Engagement,” Rand Corporation, 2017. 10 The rule stipulates that a portion of oil and gas revenues that the government can spend is determined by a fixed oil price benchmark. Currently, the benchmark oil price stands at $42 per barrel. The fiscal rule also encompasses constraints on the National Welfare Fund withdrawals in oil prices below $42 per barrel.