Commodities & Energy Sector

Highlights Both the massive inventory accumulation and robust underlying consumption have been driving Chinese crude imports in recent years. Chinese crude oil import growth will decelerate in 2021 due to a slower pace in the country’s oil inventory accumulation. The country’s underlying crude oil consumption growth will remain robust this year, which will support a still positive growth in Chinese crude oil imports this year. Strong Chinese crude oil imports are positive to global oil prices this year. Feature The gap between China’s total crude oil supply and its domestic crude oil consumption has been widening in recent years, due to a massive buildup in Chinese crude oil inventory (Chart 1A and 1B). In fact, China’s crude oil inventories have quadrupled in the past five years, exceeding two billion barrels as of November 2020 and are equal to about 70% of OECD total inventory (Chart 2). Chart 1AA Massive Buildup In Chinese Crude Oil Inventory A Massive Buildup In Chinese Crude Oil Inventory A Massive Buildup In Chinese Crude Oil Inventory Chart 1BChina: Total Crude Oil Supply Growth Has Exceeded Its Domestic Consumption Growth China: Total Crude Oil Supply Growth Has Exceeded Its Domestic Consumption Growth China: Total Crude Oil Supply Growth Has Exceeded Its Domestic Consumption Growth In addition, China’s crude oil import growth has been outpacing domestic oil consumption growth, while domestic production remains stagnant (Chart 3). Chart 2Crude Oil Inventories In China Have Quadrupled In The Past Five Years Crude Oil Inventories In China Have Quadrupled In The Past Five Years Crude Oil Inventories In China Have Quadrupled In The Past Five Years Chart 3China: Crude Oil Import Growth Has Been Stronger Than Its Domestic Consumption Growth China: Crude Oil Import Growth Has Been Stronger Than Its Domestic Consumption Growth China: Crude Oil Import Growth Has Been Stronger Than Its Domestic Consumption Growth Will China maintain its strong crude oil import growth this year? How will the interplay between domestic consumption and imports evolve in 2021? We expect China’s crude oil consumption growth to remain solid in 2021, growing at an annual rate of about 6-7% and up from the 4.5% growth rate reached in 2020. However, China’s crude oil imports are likely to increase by 4-6% in 2021 from the previous year, slower than the 7.2% growth seen in 2020. The moderation in Chinese oil imports in 2021 will mainly be due to a slower pace of crude oil inventory buildup. Understanding The Surge In Crude Oil Inventory Chart 4China's Crude Oil Inventory Buildup: One Major Driver Behind Its Strong Imports Since 2016 China's Crude Oil Inventory Buildup: One Major Driver Behind Its Strong Imports Since 2016 China's Crude Oil Inventory Buildup: One Major Driver Behind Its Strong Imports Since 2016 The massive buildup in domestic crude oil inventory has been one major driving force behind the strong growth in China's crude oil imports since 2016 (Chart 4). As oil prices continue to rebound, and given China’s existing large oil inventories, we think the pace of inventory accumulation in China will slow in 2021. Therefore, growth in Chinese oil imports this year will likely moderate. China’s crude oil imports currently account for about 75% of the country’s total crude oil supply. Since China’s domestic crude oil production has been stagnant in the last decade, the fluctuations in Chinese crude oil imports are largely driven by the change in the country’s total demand, which includes both domestic consumption and changes in inventories. China’s crude oil import growth has significantly outpaced domestic consumption growth in the past five years, leading to a buildup in inventory. China’s crude oil inventory includes Commercial Petroleum Reserves (CPR), which are held by refiners and traders; and Strategic Petroleum Reserves (SPR), which are held by the government. Our Chinese crude oil inventory proxy1 was constructed based on the crude oil flow diagram shown in Chart 5.  Chart 5How Did We Derive Our Chinese Crude Oil Inventory Proxy? Chinese Commodities Demand: An Unsustainable Boom? Part III: Crude Oil Chinese Commodities Demand: An Unsustainable Boom? Part III: Crude Oil Our research has suggested that since 2016, most of the buildup has occurred in CPR. This is due to the following: The government in 2015 required refiners to keep their inventory level at no less than their 15-days requirement for operation use. Chinese refinery capacity had been expanded at a compound annual growth rate (CAGR) of 2.8% during 2016-2019. These existing and new refineries have been building their inventories to meet government regulations in the past several years.  In addition, the government started to allow independent refineries to import crude oil by setting a quota in mid-2015, and the import quotas have been increased every year. In 2020, the quota reached 184.6 million tons, equaling to about 3,700 kbpd, nearly five times the quota in 2015. The total increase in imports of these independent refiners over the past five years was about 2,950 kbpd, accounting for 70% of the increase in the country’s total crude oil imports during the same period. Chart 6China: Rising Run Rates For Its Independent Refineries China: Rising Run Rates For Its Independent Refineries China: Rising Run Rates For Its Independent Refineries Independent refiners import crude oil for both refinery purposes and to meet the new inventory requirement. Over the last several years, the increased amount of quota has improved Chinese independent refiners’ profitability and refinery capacity run rate, as the import quota allows these private sector refiners to save operating costs by cutting out the “middleman” and by actively managing their own feedstocks. For example, Shandong has the largest number of independent refineries among all provinces. Chart 6 shows that the run rate of the region’s independent refineries has surged since 2016, from about 40% in that year to 75% this year. In addition, since 2016, the fluctuations in their run rates have become much more closely correlated with global oil prices.   Commercial crude oil users have much larger physical reserve space than the SPR. Notably, they tend to sharply increase their imports when crude oil prices are low.  In addition, inventory accumulation often occurs when credit/financing is available with low costs and refiners expect higher prices ahead. Meanwhile, our research shows the SPR development has been slowing considerably in recent years, resulting in little inventory buildup in SPR. The last time the National Bureau of Statistics (NBS) reported the SPR data was December 29, 2017. It showed the SPR was about 37.73 million tons by mid-2017, not far from the country’s target of 40 million tons for the first two phases2 of SPR. This suggests that the country was at least close to finishing its second phase of the SPR in 2017. Since then, there has been little information about the third phase of the SPR progress. We have only been able to find two pieces of news on that subject, and both suggest the construction of the third phase of SPR has been stagnant, and the planning of two sites only started in 2019. As the average construction time for projects in the second phase of SPR was about four years, we do not think these sites were completed in 2020. The NBS data shows that even during the period of mid-2015 and mid-2017, the SPR had only increased by 234 kbpd, about 117 kbpd per year. In comparison, the Chinese total crude oil inventory increased by 600-700 kbpd per year in 2016 and 2017. Clearly, SPR only accounted for a small share of the Chinese total crude oil inventory. Looking forward, we expect a much slower pace of crude oil inventory buildup in China in 2021. Our forecast is based on the following factors: Current Chinese crude oil inventories (CPR and SPR combined) are already in the upper range when comparing the OECD countries (Chart 7). Although the IEA data shows that Japan and Korea have oil stocks of 200 days and 193 days of their respective crude oil net imports, Chinese oil inventories are currently equivalent to 195 days of crude oil net imports and much higher than the 90 days the IEA requires OECD countries to hold. With Brent oil prices having risen by a lot from the April 2020 trough and elevated domestic crude oil inventories, both government and commercial users will likely slow their purchases of overseas oil for inventory accumulation. In comparison, Chinese crude oil inventory accumulation growth slowed sharply in 2018 when Brent oil prices rose by 95% from their trough in mid-2017 (Chart 8), A significant portion of Chinese oil inventory buildup was accumulated over the past five years. At 1,170 kbpd, the largest annual accumulation was in 2020, higher than the 700-900 kbpd fill per year during 2017-2019. Chart 7China's Crude Oil Inventory: No Longer Low China's Crude Oil Inventory: No Longer Low China's Crude Oil Inventory: No Longer Low Chart 8China: Rising Oil Prices Will Likely Slow Down Its Pace Of Crude Oil Inventory Accumulation China: Rising Oil Prices Will Likely Slow Down Its Pace Of Crude Oil Inventory Accumulation China: Rising Oil Prices Will Likely Slow Down Its Pace Of Crude Oil Inventory Accumulation We do not expect the fast inventory accumulation of 2020 to repeat in 2021. Instead, a mean-reversal in the inventory accumulation pace will likely occur. Table 1Our Estimates Of The Scale Of Chinese Crude Oil Inventory In 2021 Chinese Commodities Demand: An Unsustainable Boom? Part III: Crude Oil Chinese Commodities Demand: An Unsustainable Boom? Part III: Crude Oil Our baseline estimate based on China’s 2021 import quota and refinery capacity3 is that Chinese crude oil inventory will increase to 207-210 days of Chinese crude oil imports by this year-end, up from 192 days at last year-end (Table 1). With already-elevated crude oil inventory, the pace of the inventory accumulation in China will be slower than last year. Bottom Line: After a massive buildup over recent years, the pace of inventory accumulation in China will slow in 2021 and probably onwards as well. As a result, Chinese oil import growth will converge with the pace of domestic consumption growth. China’s Robust Crude Oil Consumption Growth In 2021 Chart 9China: Resilient Domestic Crude Oil Consumption Growth In 2020 China: Resilient Domestic Crude Oil Consumption Growth In 2020 China: Resilient Domestic Crude Oil Consumption Growth In 2020 Despite the pandemic outbreak, last year’s underlying consumption of crude oil in China was resilient at a year-on-year growth of 4.5%, even though the rate was smaller than the average growth of 6-7% in 2018-2019 (Chart 9).  The growth in oil consumption last year was mainly from the non-transportation sector. The output of non-transportation fuels, including fuel oil, naphtha, petroleum coke, and petroleum pitch, are mostly having impressive growth, suggesting strong consumption in sectors like chemical products, steel sector and infrastructure (Chart 10). For example, naphtha is the primary feedstock for ethylene production. Ethylene is the building block for a vast range of chemicals from plastics to antifreeze solutions and solvents. Transportation fuel consumption was weak in 2020, with the output of major transportation fuels including gasoline, diesel oil and kerosene in contraction (Chart 11). Chart 10Strong Consumption In Non-Transportation Sectors in 2020 Last Year Strong Consumption In Non-Transportation Sectors in 2020 Last Year Strong Consumption In Non-Transportation Sectors in 2020 Last Year Chart 11Transportation Fuel Consumption Was Weak In 2020 Transportation Fuel Consumption Was Weak In 2020 Transportation Fuel Consumption Was Weak In 2020 In 2021, we expect the underlying consumption growth of crude oil in China to increase to 6-7% from last year’s 4.5%. This will be in line with its growth in both 2018 and 2019 (Chart 9 on page 7). First, the consumption of transportation fuels will likely recover this year. Transportation fuels are the largest consuming sector for Chinese petroleum products. Based on British Petroleum data, gasoline, diesel and kerosene accounted for 55% of total Chinese oil consumption in 2019. We expect the transportation fuel consumption growth to be stronger (i.e., 6-7%) than its five-year compounded annual growth rate (CAGR) of 4.1% during 2015-2019. Chart 12China's Automobile Sales Correlated Well With Its Crude Oil Imports China s Automobile Sales Correlated Well With Its Crude Oil Imports China s Automobile Sales Correlated Well With Its Crude Oil Imports Automobile sales in China correlated well with the country’s crude oil imports (Chart 12, top panel). Despite a year-on-year contraction of 2% for the whole year of 2020, automobile sales had been strong with a double-digit growth nearly every month since May. Only 5% of these automobiles are new energy vehicles (NEV). About 80% of them are gasoline cars and 15% are diesel automobiles. Annual total car sales still account for about 9% of total existing automobiles (Chart 12, bottom panel). This means a 6-7% growth in the transportation consumption of passenger cars and commercial cars is very possible in 2021. The number of airports and airplanes are still on the uptrend in China. The CAGR of Chinese kerosene consumption rose from 10.1% during 2010-2014 to 10.6% during 2015-2019. This suggests that the kerosene consumption growth in China could reach 11% in 2021. Domestic gasoline and diesel prices are near decade lows (Chart 13). This will encourage consumption of these fuels. Second, the oil consumption growth in the industry sector will likely be larger than the 5% in the recent years (Chart 14). Based on the NBS data, the industry sector accounts for about 36% of China’s petroleum product consumption. Chart 13Low Domestic Gasoline And Diesel Prices Encourage Fuel Consumption This Year Low Domestic Gasoline And Diesel Prices Encourage Fuel Consumption This Year Low Domestic Gasoline And Diesel Prices Encourage Fuel Consumption This Year Chart 14Robust Oil Consumption Growth In The Industry Sector In 2021 Robust Oil Consumption Growth In The Industry Sector In 2021 Robust Oil Consumption Growth In The Industry Sector In 2021 Third, infrastructure spending and property market construction will slow in 2H2021 given the credit, fiscal, and regulatory tightening that has been taking place. However, construction only accounts for about 6% of Chinese petroleum product consumption.  Given all of this, achieving a 6-7% underlying consumption growth of crude oil in China this year is possible. Taking into consideration the slower pace of inventory buildup, we expect China’s crude oil imports to increase by 4-6% in 2021 over the previous year, slower than last year’s 7.2% growth. Bottom Line: The underlying consumption growth of crude oil in China is likely to increase to 6-7% in 2021 from last year’s 4.5%, providing solid support to China’s crude oil imports. What About Other Factors Affecting Chinese Crude Oil Imports? Currently, both domestic crude oil production and net exports of Chinese petroleum products exports are small contributors to the growth of Chinese crude oil imports. However, as the Chinese petroleum export sector becomes more competitive in the global market, it will likely take a bigger share of China’s crude oil imports going forward. Chart 15Net Exports Of Chinese Petroleum Products Are On The Uptrend Net Exports Of Chinese Petroleum Products Are On The Uptrend Net Exports Of Chinese Petroleum Products Are On The Uptrend We expect domestic crude oil output to be stagnant in 2021. The breakeven prices for most domestic oil fields are US$50-60 per barrel. Without a considerable rally in oil prices, the total domestic crude oil output is unlikely to pick up. Moreover, due to the massive crude oil inventory buildup in recent years, Chinese oil producers may constrain their output. In this scenario, a reduction in domestic crude oil output by 1-2% in 2021 from 2020 is possible. Nonetheless, this will only increase China’s oil imports by a small amount of about 40-80 kbpd. The net exports of Chinese petroleum products are on the uptrend (Chart 15). Currently net exports of Chinese petroleum products account for only about 6% of Chinese crude oil imports.  However, Chinese refineries are increasingly competitive in global gasoline and diesel markets, since most of the new refineries in the country are high technology equipped and highly efficient. In addition, last July, China started issuing export licenses to private refiners, and we expect the trend to continue. According to Bloomberg, China is set to surpass the US to become the world’s largest oil refiner in 2021. As such, in the coming years we expect rising Chinese exports of petroleum products will demand more imports of crude oil.  We expect Chinese petroleum products net exports to rise by 100-150 kbpd in 2021 15-20% growth from last year), which may increase our estimate of China’s year-on-year crude oil import growth from 4-6% to 5-7% in 2021. However, increasing Chinese petroleum product exports does not increase global final demand for oil. It cannot be viewed as a fundamentally bullish factor for oil prices. Bottom Line: Stagnant domestic crude oil output and rising net exports of Chinese petroleum products will also lead to an increase of China’s crude oil imports.  Investment Implications Chart 16China: An Increasingly Important Factor For Global Oil Demand China: An Increasingly Important Factor For Global Oil Demand China: An Increasingly Important Factor For Global Oil Demand Strong crude oil imports by China have supported global oil prices in recent years. China has become an increasingly important driving force of global oil demand. Its oil imports currently make up about 12% of global oil demand, more than doubled from a decade ago (Chart 16). The country’s crude oil imports will continue expanding this year. Even at a slower rate, the robust oil consumption and imports from China will remain a positive factor for global oil prices in 2021. Beyond 2021, however, the country’s crude oil import growth outlook is facing increasing downside risks. Demand that is due to inventory accumulation is ultimately finite and non-recurring. Moreover, more oil accumulations in 2021 on top of China’s already elevated oil inventories may weigh on Chinese oil imports beyond 2021. In the meantime, US crude oil producers may benefit from continuing strong purchases from China. In 2020, China significantly ramped up its crude oil imports from the US, as the country has pledged to boost purchases of US energy products under the phase one trade deal signed with President Trump in January 2020. Chart 17Chinese Imports Of US Crude Oil May Continue To Rise In 2021 Chinese Imports of US Crude Oil May Continue To Rise In 2021 Chinese Imports of US Crude Oil May Continue To Rise In 2021 In 2020, Chinese imports of US crude oil in volume terms were 155% higher from a year before (Chart 17, top panel). Its share of total Chinese crude oil imports also spiked from 1-2% in late 2019 to 7-8% in the past several months (Chart 17, bottom panel). In the meantime, China’s share of US crude oil export also jumped from 4.6% in 2019 to 14.7% last year. In 2021, our baseline view is that China will want to show goodwill to the newly elected Biden administration by continuing to boost its crude oil purchase from the US. This will benefit US crude oil producers. However, if China buys more from the US, it may buy less from other countries.   Ellen JingYuan He  Associate Vice President ellenj@bcaresearch.com     Footnotes 1By deducting crude oil used in refineries and in direct final consumption from the total supply, we derived the flow of inventory and the level of changes in inventory. By using the cumulative value of the flow inventory data, we were able to derive the stock of inventory. We assume the initial inventory in 2006 was zero. This assumption is reasonable as the first fill of the SPR was in 2007 and the stock of CPR was extremely low at that time as well. In addition, based on the data from the National Bureau of Statistics, we found out that the direct final consumption of crude oil without any transformation only accounted for about 1-2% of total supply. 2 In 2004, the government planned three phases of SPR construction, targeting 10-12 million tons of crude oil SPR for the first phase, 28 million tons for the second phase, and another 28 million tons for the third phase. 3The import quota for independent refiners in 2021 has been increased by 20% (about 823 kbpd), and the country’s refinery capacity will expand at about 500 kbpd per year over 2021-2025. Cyclical Investment Stance Equity Sector Recommendations

Dear client, In lieu of our regular report next Friday, we will be sending you a special report on Australia next Tuesday, co-authored with our Global Fixed Income colleagues. We hope you will find the report insightful. Kind regards, Chester   Highlights Any tactical bounce in the dollar should be limited to 2-4%. A barbell strategy is the most attractive positioning in the next one to three months: a basket of the cheapest currencies and some safe havens. Remain short the gold/silver ratio. Feature Chart I-1Dollar Downside Hits Q1 Forecasts Dollar Downside Hits Q1 Forecasts Dollar Downside Hits Q1 Forecasts The market narrative towards the dollar is turning more bullish. Fundamental analysts point to the recent rise in US interest rates, relative to countries like Germany or the United Kingdom, as a serious cause for concern. A rules-based technical approach certainly warned that the dollar was getting much oversold last year, and the recent bounce is reinvigorating the possibility of a more powerful countertrend move. Being in the dollar-bearish camp, the key question is: how large could a potential dollar bounce be, and for how long can it last? According to Bloomberg forecasters, the dollar has already exhausted any potential decline penciled in for the first quarter of this year. Q1 consensus forecasts for the DXY index sit at 90, exactly where the index level rests today (Chart I-1). Bloomberg has consistently lowballed the level of the dollar since 2018, making the current forecast unduly bullish. This dovetails with recent market commentary that the decline in the dollar is largely done, and powerful catalysts for a countertrend move could take hold. Risks From The Reflation Trade Chart I-2A Stock Market Rout Could Derail The Dollar A Stock Market Rout Could Derail The Dollar A Stock Market Rout Could Derail The Dollar An equity market correction could be one of the potential catalysts that pushes the dollar higher. We showed last week that the dollar and the S&P 500 have had a near-perfect inverse correlation (Chart I-2). When a stock market and its currency exhibit an inverse correlation, it means that foreign investors have been hedging their equity purchases by selling the currency forward. This is not usually the norm (equity relative performance and currencies tend to move together), but was especially the case last year as inflows into US equities surged, but the dollar declined. Should any profit taking ensue, this will trigger a knee-jerk rally in the dollar, as forward shorts are closed. A few equity indicators warn that we could be at the cusp of such a counter-trend move:  The put/call ratio in the US is extremely depressed. This warns that positioning is lopsided and could easily topple the equity market rally. A rising put / call ratio has been synonymous with a higher dollar over the past few years (Chart I-3). This will be consistent with foreign investors unwinding their dollar hedges (as they take profits on equities) and/or safe-haven inflows into the dollar. Chart I-3Both Puts And The Dollar Offer Protection Both Puts And The Dollar Offer Protection Both Puts And The Dollar Offer Protection Cyclical stocks continue to outperform defensive ones of late, but the cracks are beginning to emerge, specifically in the industrials space. Industrials share prices have been relapsing of late (Chart I-4). The dollar tends to weaken when cyclical stocks are outperforming defensive ones, and vice versa. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. The huge correction in the relative performance of the global tech sector also warns that the tech-heavy US bourse might benefit from any bounce in tech equities. Global earnings revisions are heading higher, but the momentum of US earnings has regained the upper hand, especially relative to the euro area. Bottom-up analysts are usually too optimistic about the level of earnings, but are generally spot on about their direction. Relative earnings revisions between the US and other markets have led the dollar by about nine to 12 months (Chart I-5). Should cyclical earnings hit a soft patch as the pandemic engulfs much of the developing world, the more defensive US market might prove resilient. Chart I-4A Red Flag From Global Industrials A Red Flag From Global Industrials A Red Flag From Global Industrials Chart I-5Earnings Revisions And The Dollar Earnings Revisions And The Dollar Earnings Revisions And The Dollar In a nutshell, corrections in equity markets are usually a healthy reset for the bull market to resume. In similar fashion, a washing out of stale US dollar short positions will ensure the bear market for 2021 unfolds with higher conviction. A garden-variety 5-10% cyclical correction in the S&P 500 has usually coincided with a 2-4% bounce in the DXY, as can be seen from Chart I-2. This could be the story over the next one to three months. The Signal From Currency Markets Our dollar capitulation index hit a nadir in July last year and has since been rebounding from very oversold levels. It has been very rare that a drop in this index below the 1.5 level did not trigger a rebound in the dollar (Chart I-6). Part of the reason this did not happen this time around has been concentration. Dollar short positions since 2020 have mostly been against the euro, yen and Swiss franc, with positioning in currencies such as the Australian dollar and Mexican peso more neutral. This will limit the extent to which the broad dollar index could rise from a flushing out of stale shorts. Chart I-6BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside For example, the exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate. Since the Great Recession, the yen has been the best performer during equity drawdowns, while the Aussie has been the worst. As a result, the AUD/JPY cross has consistently tracked the drawdown of the broad equity market (Chart I-7). As the bottom panel shows, exuberance in the AUD/JPY cross has also coincided with equity market peaks.  That exuberance hardly exists today. The AUD/JPY cross has consistently tracked the drawdown of the broad equity market. That said, speculators are very short the dollar, even if the currencies used to implement these views are very concentrated. Sentiment towards the dollar is the lowest in over a decade and our intermediate-term indicator is at bombed-out levels (Chart I-8). Chart I-7AUD/JPY As A Risk On Gauge AUD/JPY As A Risk On Gauge AUD/JPY As A Risk On Gauge Chart I-8The Dollar Is Oversold The Dollar Is Oversold The Dollar Is Oversold In a nutshell, the message from technical indicators is that a bounce in the dollar is to be expected. However, the magnitude will be smaller than prior episodes. 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.  The Dollar And Commodities Commodity prices across the board have been on a tear. This has usually been an environment where the dollar is in a broad-based decline. Commodity prices hold a special place as FX market indicators, since they are both driven by final demand and financial speculation. More importantly, rising commodity demand can signal an improving FX trend between commodity producing (Australia, Canada, Mexico, Colombia, Russia) and importing (Euro area, India, Turkey, or even China) countries. We will buy the currencies of commodity producers on weakness as the bull market continues. Metals prices have exploded higher on strong demand, especially from China (Chart I-9). Not surprisingly, speculative positioning in copper options and futures is also extremely elevated. If investors have been betting on higher copper prices, based on the expectation of a lower dollar, then a relapse in the red metal will be synonymous with a higher greenback. That said, commodity bull markets have tended to last over a decade, with the recent rise in prices also driven by deficient supply. As such, we will buy the currencies of commodity producers on weakness, rather than sell on strength, as the bull market continues. This also argues for a fleeting technical bounce in the dollar. Chart I-9A Bull Market In Metals A Bull Market In Metals A Bull Market In Metals Chart I-10The Gold/Silver Ratio is Rebounding The Gold/Silver Ratio is Rebounding The Gold/Silver Ratio is Rebounding Within the commodity space, watching the gold/silver ratio (GSR) is instructive. The GSR tends to track the US dollar (Chart I-10). This is because it has usually rallied on safe-haven demand and relapsed once there is a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. It is possible the surge in global infections dampens economic activity and lifts demand for safe havens. This will be good for the dollar. However, as vaccinations take hold and the economy reopens, silver will surge. Relative Interest Rates Interest rates are moving in favor of the dollar, and there has been a long-standing relationship between relative real rates and the US currency. The question is whether the rise in US interest rates has been sufficient to compensate investors for the higher budget deficits they will need to finance. To answer this, it is always instructive to look at the relationship between gold and US Treasuries. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s.  The bond-to-gold ratio is an important signal for the dollar, since both US Treasuries and gold are safe-haven assets and thus, by definition, are competing assets (Chart I-11). The ratio of the US bond ETF (TLT)-to-gold (GLD) is an important proxy for investor sentiment on the dollar (Chart I-12). Ultimately, investors are driven by real rates. Positive real returns will favor Treasuries, while negative real returns will favor gold. The latter appears to have the upper hand for now. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s. Chart I-11Gold and Treasurys Are Competing Assets Gold and Treasurys Are Competing Assets Gold and Treasurys Are Competing Assets Chart I-12Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio The implication is that the rise in US interest rates has not yet convinced investors that a significant margin of safety exists for possible runaway inflation. This augurs badly for the dollar, beyond the near term. Investment Implications Our investment strategy is simple: hold a basket of the cheapest currencies and, some safe havens that will benefit if the dollar bounces. Opportunities at the crosses also make sense. On safe-haven currencies, our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Relative value is particularly attractive on short CAD/NOK, long AUD/NZD, short EUR/GBP and long EUR/CHF. Stick with them. Stay short USD/JPY and long the Scandinavian currencies as a core holding. Remain short the gold/silver ratio.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been resilient: The headline 140K job loss last Friday was not as dire, looking into the details. There was a net two-month revision of +135K jobs. Core CPI came in line at 1.6% year-on-year, while average weekly earnings surged by 4.9%. MBA mortgage applications came in at a blockbuster 16.7% week-on-week, for the week ending on January 8. The DXY rose by 0.3% this week. There was some element of consolidation in markets earlier this week, with a few equity bourses softening and the dollar catching a bid. However, that has been overwhelmed by the reflation trade as we go to press. We expect any dollar bounce to be technical in nature, and in order of magnitude of around 2-4%.  Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have help up: The unemployment rate in the euro area fell from 8.4% to 8.3% in November. Sentix investor confidence remains resilient at 1.3 in January, versus -2.7 the previous month. Industrial production in the euro area is recovering, as signaled by the PMI releases. The euro fell by 0.5% against the US dollar this week. The unfolding political crisis in Italy warns that the euro might be due for a setback, as European peripheral bond spreads rise. We remain bullish the euro longer-term, but short-term trades are at risk from lopsided positioning.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been better than expected: The expectations component of the Eco Watchers Survey rose from 36.5 to 37.1, versus expectations of 30.5 in December. Machine tool orders continued to inflect higher in December, to the tune of 8.7% year-on-year. Bank lending remained around a robust 6% in December. The Japanese yen was flat against the US dollar this week. Japanese fixed income investors are in a quagmire, since nominal rates are better in the US, but real rates are more favorable in Japan. The yen could remain caught in a tug of war between these forces, with a slight advantage to Japanese rates. We remain long the yen as a portfolio hedge.   Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There was scant data out of the UK this week: BRC like-for-like sales rose by 4.8% year-on-year in December. The British pound rose by 0.8% against the US dollar this week. Vaccinations continue to progress smoothly in the UK, but cracks are already starting to emerge in the post Brexit UK-EU relationship. There are mounting food shortages in Northern Ireland and a hiccup in fish exports from the UK, as the necessary paperwork adds a layer of bureaucracy. As investors digest the potential impact to the pound, it will add to volatility. Ultimately, a cheap pound should outperform both the dollar and euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was little data out of Australia this week: The final retail sales print was 7.1% month-on-month in November. The Australian dollar appreciated by 0.4% against the US dollar this week. Base metals, especially copper and iron ore have been on a tear this year. This is boosting Australian terms of trade. More importantly, a shortage of ships has catapulted Asian LNG prices to all-time highs as a cold spell hits countries like Japan and Korea. This should be beneficial for Australian energy producers. We are currently long AUD/NZD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week: REINZ house sales rose by 36.6% year-on-year in December. Building permits rose 1.2% month-on-month in November. The New Zealand dollar fell by 0.3% against the US dollar this week. The release of the US WASDE report confirmed a looming agricultural shortage, as production forecasts were slashed on weather worries. This is NZD bullish. That said, technically, agricultural prices are stretched, and so some consolidation will deflate air off the high-flying kiwi. In a commodity basket, we prefer the Aussie that is underpinned by more structural factors. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been disappointing: Employment fell by 62.6K jobs in December. However, this was driven by 99K part-time job losses, with full-time job gains of 36.5K. The sales outlook in the BoC survey improved from 39 to 48 in 4Q 2020. The Canadian dollar appreciated by 0.5% against the US dollar this week. Oil prices are dominating commodity gains this year, given the shift from Saudi Arabia and the prospect of higher transport demand. This bodes well for the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been mixed: The unemployment rate was flat at 3.4% in December. FX reserves increased from CHF 876 billion to CHF 891 billion. The Swiss franc fell by 0.2% against the US dollar this week. The biggest risk to Switzerland and the SNB authorities is a potential correction in the euro, which encourages safe-haven flows into the franc. This will also be a risk to our long EUR/CHF position. Our bias is that the valuation cushion on the cross provides an ample margin of safety. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: Headline CPI came in at 1.4% year-on-year, while underlying CPI was a whopping 3%. House prices rose 2.9% quarter-on-quarter in Q4. Industrial production came in at -0.9% in November, an improvement from -2.7% the previous month. The Norwegian krone is the best performing currency this year at +1.5%. Good management of the COVID-19 situation as well as rising oil prices have been positive catalysts. We expect the krone to keep outperforming for the rest of the year. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden has been rather disappointing: Private sector production fell by 1% year-on-year in November. We would expect this to reverse with the improvement in the December PMIs. Industrial orders rose 5.7% year-on-year in November. Household consumption fell 5% year-on-year in November. The Swedish krona has been the worst performing currency this year, falling by 0.7% against the US dollar this week. That said, it might be a case of profit taking. The Swedish krona remains cheap and should benefit from an upshot in the global manufacturing cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In the wake of COVID-19, the low-probability, high-impact “Black Swan” event is as relevant as ever. Investors should already expect US terrorist incidents, a fourth Taiwan Strait crisis, and crises involving Turkey – these are no longer black swans. What if Russia had a color revolution, Japan confronted China, or Saudi Arabia collapsed? What if the US and China brokered a North Korean deal? Or a major terrorist attack caused government change in Germany? Ultimately this exercise illustrates what the market is not prepared for – a new rally in the US dollar – though some scenarios would fuel the rise of the euro and renminbi. Feature The COVID-19 pandemic reminded us all of the power of the “Black Swan” – the random, unpredictable event with massive ramifications. As historian Niall Ferguson pointed out at the BCA Conference last fall, COVID-19 was not really a black swan, as epidemiologists had predicted that a pandemic would occur and the world was not ready. Astrophysicist Martin Rees made a bet with psychologist and linguist Steven Pinker that “bioterror or bioerror will lead to one million casualties in a single event within a six month period starting no later than 31 December 2020.”1 Tellingly, countries neighboring China were the best prepared for the outbreak, having dealt with SARS and bird flu. COVID accelerated major trends building up throughout the past decade – notably the shift toward pro-active fiscal policy, which had been gaining traction in policy circles ever since the austerity debates of the early 2010s. In that sense forecasting is still necessary. If solid trends can be identified, then random shocks may simply reinforce them (Chart 1). Chart 1US Fiscal Stimulus About To Get Even Bigger Five Black Swans For 2021 Five Black Swans For 2021 In this year’s “Five Black Swans” report, we focus on geopolitical risks that are highly unlikely, not at all being discussed, and yet would have a major impact on financial markets. Domestic terrorist events in the United States in 2021 would not qualify as a black swan by this definition. A crisis in the Taiwan Strait, which we have warned about for several years, is now widely (and rightly) expected. Black Swan #1: A Color Revolution In Russia Russia is one of the losers of the US election. Not because Trump was a Russian agent – the Trump administration ended up authorizing a fairly hawkish posture toward Russia in eastern Europe – but rather because the Democratic Party threatens Russia with a strengthening of the trans-Atlantic alliance and a recovery of liberal democratic ideology. Geopolitical risk surrounding Russia is therefore elevated, as we argued last year. Both President Vladimir Putin and his government have seen their approval rating drop, a development that has often led Russia to lash out abroad (Chart 2). But our expectation of rising political risk within Russia’s sphere has been reinforced by Russia’s alleged poisoning of opposition politician Alexei Navalny and the eruption of pro-democracy protests in Belarus. Vladimir Putin is increasingly focusing on home affairs due to domestic instability worsened by the pandemic and recession. Fiscal and monetary austerity have weighed on the public. The largest protests since 2011 occurred in mid-2019 in opposition to the fixing of the Moscow municipal elections. This could be a harbinger of larger unrest around the Russian legislative elections on September 19, 2021. Nominal wage growth has collapsed and is scraping its 2015-16 lows (Chart 3). Chart 2Black Swan #1: A Color Revolution In Russia Black Swan #1: A Color Revolution In Russia Black Swan #1: A Color Revolution In Russia Chart 3Russia's Fiscal Austerity Russia's Fiscal Austerity Russia's Fiscal Austerity Meanwhile US policy toward Russia will become more confrontational. New US presidents always start with outreach to Russia, but the Democratic Party blames Russia for betraying the good faith of the Obama administration’s “diplomatic reset” from 2009-11. Russia invaded Ukraine and took Crimea in exchange for cooperating on the 2015 Iran nuclear deal. Adding in the Snowden affair, the 2016 election interference, and now the monumental SolarWinds cyberattack, the Democratic Party will want to strike back and reestablish deterrence against Russia’s asymmetrical warfare. While Biden will seek to negotiate an extension of the New START missile treaty from February 5, 2021 until 2026, he will gear up for confrontation in other areas. The US could seek to go on offense with Russia’s wonted tools: psychological warfare and cyberattacks. The Americans are not willing or able to attempt regime change in Moscow. That would be taken as an act of war among nuclear powers. But if Russia is less stable internally than it appears, then US meddling could hit a weak spot and set off a chain reaction. Even if the US is incapable of anything of the sort, Russia is still ripe for social unrest. Should the authorities mishandle it, it could metastasize. Russia has a long tradition of peasant uprisings – a descent into anarchy is not out of the question. The regime would not be devoting so much attention to suppressing domestic dissent if the conditions for it were not ripe.2 Putin’s constitutional reforms in mid-2020, which could extend his term until 2036, also speak to concerns about regime stability. A successful Russian uprising would threaten to raise serious instability in Europe and the world. When great but decadent empires are destabilized, political struggle can intensify rapidly and spill out to affect the neighbors. Bottom Line: Russian domestic political instability could produce a black swan. The ruble would tank and the US dollar would catch a bid against European currencies. Black Swan #2: A Major Terror Attack In Germany 2020 was a banner year for European solidarity. Brexit went forward but none of the European states have followed – nor would any want to follow given the political turmoil it aroused. Brussels initiated a recovery fund to combat the global pandemic that consisted of a mutual debt scheme – in what has been hailed somewhat excessively as a “Hamiltonian moment,” a move toward federalism. Germany stood at the center of this process. After opening the doors to a flood of migrants from Syria in 2015, Chancellor Angela Merkel suffered a blow to her popularity and was eventually forced to make plans for her exit. But she stuck to her core liberal policies and her fortunes have recovered (Chart 4). She is stepping down in 2021 as the longest-serving chancellor since Helmut Kohl and an influential European stateswoman. The EU member states are more integrated than ever while Germany has taken another step toward improving its international image. The public has rewarded the ruling coalition for its relatively competent handling of the global pandemic (Chart 5). Chart 4Black Swan #2: A Major Terror Attack In Germany Black Swan #2: A Major Terror Attack In Germany Black Swan #2: A Major Terror Attack In Germany Chart 5German People Happy With Their Government Five Black Swans For 2021 Five Black Swans For 2021 Merkel’s approval coincides with a recovery of the liberal democratic consensus in Europe after a series of challenges from anti-establishment and populist parties. Only in Italy did populists take power, and they were forced to back down from their extravagant fiscal policy demands while modifying their policy platform with regard to membership in the monetary union. Even today, as Italy’s ruling coalition comes apart at the seams, the risk of a populist backlash is lower than it was in most of the past decade. One of the main ways the European establishment neutralized the populist challenge was by tightening control over immigration and cracking down on terrorism (Charts 6 and 7). These two forces have played a large role in generating support for right wing parties, and these parties have declined in popularity as these two forces have abated. Chart 6Terrorist Attacks Have Fallen In Europe Terrorist Attacks Have Fallen In Europe Terrorist Attacks Have Fallen In Europe Chart 7Europeans Softening Toward Immigrants? Europeans Softening Toward Immigrants? Europeans Softening Toward Immigrants? Still, the risk posed by terrorist groups has not disappeared – and it is always possible that disaffected individuals could evade detection. French President Emmanuel Macron faced seven terrorist attacks over the past year, which partly stemmed over the commemoration of the Charlie Hebdo massacre but also points to the persistence of underground extremist networks (Chart 8).3 Chart 8French Fear Of Terrorism Has Increased Five Black Swans For 2021 Five Black Swans For 2021 Chart 9European Breakup Risk At Testing Point European Breakup Risk At Testing Point European Breakup Risk At Testing Point What would happen if a major attack occurred in Germany in 2021? Would it upset the country’s liberal consensus and fuel another surge in popular support for far-right parties like the Alternative for Germany? Only a major attack would have a lasting impact. A systemically important attack in the pivotal year of Merkel’s retirement could create more uncertainty in domestic German politics than has been seen since the 1990s and early 2000s. It is possible that an attack could strengthen the ruling coalition and the public’s desire to continue with the leadership of the Christian Democrats after Merkel. More likely, however, it would divide the conservative and right-wing parties among themselves. Merkel’s chosen successor, Defense Minister Annagret Kramp-Karrenbauer, was forced to abandon her bid for the chancellorship last year after members of her Christian Democratic Union in the state of Thuringia voted along with the anti-establishment Alternative for Germany to remove the state’s left-wing leader. The cooperation was minimal but it set off a firestorm by suggesting that Kramp-Karrenbauer was willing to work together with the far right.4 She bowed out and now the party is about to pick a new leader. The point is that if any event strengthens the far right, it would suck away votes from the Christian Democrats. The latter could also see divisions emerge with their Bavarian sister party, the Christian Social Union, which has differed on immigration in the past. Or the conservatives could alienate the median German voter by tacking too far to the right to preempt the anti-establishment vote (e.g. overreacting to the attack). Either way, German politics would be rocked. Ironically, if the coalition was seen as mishandling the response, a left-wing coalition of the Greens and the Social Democrats could be the beneficiaries. The risk of a government change – in the wake of Merkel and the pandemic – is greatly underrated, entirely aside from black swans. Nevertheless a major shock that strengthens the far right would be a black swan by forcing the question of whether the center-right is willing to cooperate with its fringe. If that occurred, then Europe would be stunned. If it did not, then the conservatives could lose the election and plunge into intra-party turmoil. The takeaway of a rightward shift on the back of any shock would be a renewed risk of fiscal hawkishness – a partial relapse from the past two years’ fiscal expansion to the more traditionally austere German posture. The takeaway of a leftward shift would be the opposite – a doubling down on that fiscal expansion. German hawkishness would increase the European breakup risk premium, while a confirmation of the new German dovishness would further suppress it (Chart 9). Bottom Line: The fiscal dovish turn is the more likely response to such a black swan in today’s climate, but a major terrorist attack could have unpredictable consequences. Black Swan #3: A US-China Deal On North Korea Critics misunderstood President Trump’s policy on North Korea. Trump’s policy – even his belligerent rhetoric – echoed that of Bill Clinton in the 1990s. The intention of the US show of force was to create an overwhelming threat that would force Pyongyang into serious negotiations toward a nuclear deal. That in turn would pave the way to economic cooperation. Trump’s efforts failed – Kim Jong Un stonewalled him in the final year and a half. Kim’s bet paid off since he avoided making major concessions and now Biden must start from scratch. Pyongyang has ramped up its threats and Kim has elevated his sister, Kim Yo Jong, to a higher standing in the party – apparently to lob attacks at South Korea full-time. Biden will put the technocrats and Korea experts in charge. Pyongyang may test nuclear weapons or launch intercontinental ballistic missiles to attract Biden’s attention. But Kim could also go straight to negotiations. Optimistically, a few years of talks could result in a phased reduction of sanctions in exchange for nuclear inspections. Kim has the incentive and the dictatorial powers to open up the economy and engage in market reforms while managing any backlash among the army. He has already prepared the ground by elevating economic policy to the level of military policy in the national program. For years he has allowed some market activity to little effect. The North must have suffered from the pandemic, as Kim publicly confessed to the failure of economic management at the latest party meeting. His country needs a vaccine for COVID. And if he intends to go the way of Vietnam, then he needs to open up the doors while a new global business cycle is beginning (Chart 10). The black swan would emerge if the Biden administration’s attempt to reboot relations with China produced a unified effort to force a resolution onto Kim. It is undeniable that Trump broke diplomatic ice by meeting with Kim directly, giving Biden the option of doing so quickly and with minimal controversy if he should so desire. Most importantly, China has enforced sanctions, if official statistics can be trusted (Chart 11). Beijing made no secret that it saw North Korea as an area of compromise to appease US anger. After all, success on the peninsula would remove the reason for the US to keep troops there. Chart 10Black Swan #3: A US-China Deal On North Korea Five Black Swans For 2021 Five Black Swans For 2021 Chart 11An Area Of US-China Cooperation Under Biden? An Area Of US-China Cooperation Under Biden? An Area Of US-China Cooperation Under Biden? The last point is the material point. If the North sought to open up, it would likely have to do so through talks with the US, China, South Korea, and Japan. Success would mean that US-China engagement is still effective. Bottom Line: A breakthrough on the Korean peninsula would mean that investors could begin imagining a future in which the US and China are not “destined for war” but rather capable of reviving their old cooperative approach. This has far-reaching positive implications, but most concretely the Korean won and Chinese renminbi would rally against the US dollar and Japanese yen on the historic reduction of war risk. Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Saudi Arabia is an even greater loser from the US election than Russia. The Saudis came face to face with their geopolitical nightmare of US abandonment under the Obama administration, as the US gained energy independence while reaching out to Iran. The 2015 nuclear deal gave Iran a strategic boost and enabled it to resume pumping oil (Chart 12). The Saudis, like the Israelis, lobbied hard to stop the deal but failed. They threw their full support behind President Trump, who reciprocated, and now face the restoration of the Obama policy under Joe Biden. Chart 12Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Chart 13Fiscal Pressure On Saudis Fiscal Pressure On Saudis Fiscal Pressure On Saudis Global investors should expect Biden to return to the nuclear deal with Iran as quickly as possible, notwithstanding Iran’s latest nuclear provocations, since the latter are designed to increase negotiating leverage. The Joint Comprehensive Plan of Action was an executive agreement that Biden could restore with the flick of his wrist, as long as Iranian President Hassan Rouhani returned to compliance. Rouhani can do so before a new president is inaugurated in August – he could secure his legacy at the cost of taking the blame for “dealing with the devil.” This would save the regime from further economic and social instability as it prepares for the all-important succession of the supreme leader in the coming years. A black swan would occur if this diplomatic situation led to a breakdown in support for Crown Prince Mohammed bin Salman (MBS). MBS, whose nickname is “reckless,” in part because his foreign policies have backfired, could attempt to derail or sabotage the US-Iran détente. If he tried and failed, the US could effectively abandon Saudi Arabia – energy self-sufficiency, public war-weariness, and Iranian détente would pave the way for the US to downgrade its commitment. This would create an existential risk for the kingdom, which depends on the US for national security. It could also be the final straw for MBS, who already faces opposition from elites who have been shoved aside and do not wish to see him ascend the throne in a few years’ time. A different trigger for the same black swan would be a collapse of the OPEC 2.0 oil cartel. The Saudis and Russians have fought two market-share wars over the past seven years. They could relapse into conflict in the face of shifting global dynamics, such as the green energy revolution, that disfavor oil. Arthur Budaghyan and Andrija Vesic, of BCA’s Emerging Markets Strategy, have argued that financial markets will start pricing in a higher probability of Saudi currency depreciation versus the US dollar in coming years. Lower-for-longer oil prices (say $40 per barrel average over next few years) would pose a dilemma to the authorities: either (1) cut fiscal spending further and tighten liquidity or (2) resort to local banks financing (money creation “out of thin air”) to sustain economic activity. The first scenario would impose severe fiscal austerity on the population (Chart 13), which is politically difficult to endure in the long run. The second scenario will lead to depleting the country’s FX reserves, robust money growth and some inflation culminating in downward pressure on the currency. The main reason for believing the devaluation will not happen is that it would topple the regime. Currency devaluation would result in unbearable inflation in a country that lacks domestic production and domestically sourced staples. But that is precisely why it is a black swan risk. After all, prolonged fiscal austerity may not be feasible either. Bottom Line: MBS controls the security forces and has consolidated power for years but that may not save him if his foreign policies led to American abandonment or a breakdown of the peg. Black Swan #5: A Sino-Japanese Crisis For the first time since 2016, we are not including US-China tensions over Taiwan in our list of black swans. A crisis in the strait is only a matter of time and the global news media is increasingly aware of it (Chart 14). It would not necessarily have to be a war or even a show of military force, though either are possible. A mere Chinese boycott or embargo of Taiwan would violate the US’s Taiwan Relations Act and trigger a US-China crisis from the get-go of the Biden administration. What is less widely recognized is that peaceful resolution of the China-Taiwan predicament is not just a concern for the United States. It is a concern for Japan and South Korea as well – whose vital supplies must travel around the island one way or another. These two nations would face constriction if mainland China reunified Taiwan by force – and therefore Beijing’s signals of increasing willingness to contemplate armed action are already reverberating among the neighbors. Japan sounded an uncharacteristically stark warning just last month. The hawkish statement from State Minister of Defense Yasuhide Nakayama is worth quoting at length: We are concerned China will expand its aggressive stance into areas other than Hong Kong. I think one of the next targets, or what everyone is worried about, is Taiwan … There’s a red line in Asia – China and Taiwan. How will Joe Biden in the White House react in any case if China crosses this red line? The United States is the leader of the democratic countries. I have a strong feeling to say: America, be strong!5 China and Japan have improved trade relations through the RCEP agreement, as Beijing looks to diversify from the United States. But China’s rise is of enormous strategic concern for Japanese policymakers. COVID-19 and the rollback of Hong Kong’s freedoms have made matters worse. The belt of sea and land around China – the “first island chain” – is the critical area from which Beijing seeks to expel American and foreign military presence. With China already having shown a willingness to clash with India and Australia simultaneously in 2020 – as it carves a sphere of influence in the absence of American pushback – it should be no surprise to see conflicts erupt in the East or South China Sea (Chart 15). Chart 14Differences In The Taiwan Strait Differences In The Taiwan Strait Differences In The Taiwan Strait Chart 15Black Swan #5: A Sino-Japanese Crisis Black Swan #5: A Sino-Japanese Crisis Black Swan #5: A Sino-Japanese Crisis In the aftermath of the last global crisis, in 2010, China and Japan clashed mightily over maritime-territorial disputes in the East China Sea. China imposed a brief embargo on exports of rare earth elements to Japan. The two clashed again the following year and tensions escalated dramatically when China rolled out an Air Defense Identification Zone (ADIZ) in 2013. Tense periods come and go and are often attended by mass anti-Japanese protests, as in 2005 and 2012. Usually these events are of passing importance, though they have the potential to escalate. What would truly be a black swan would be if Japan took the initiative to challenge China and test the Biden administration’s commitment to Japanese security. With the US internally divided and distracted, and China ascendant, Japan could grow increasingly insecure and seek to take precautions. China could see these as offensive. A new Sino-Japanese crisis could ensue that would catch investors by surprise. It is highly unlikely that Tokyo would provoke China – hence the black swan designation – but the effective absence of the Americans is a strategic liability that Tokyo may wish to resolve sooner rather than later. In this case the market reaction would be predictable – the yen would appreciate while the renminbi and Taiwanese dollar would fall. The risk-off period could be extended if the US failed to reinforce the Japanese alliance for fear of China, with the whole world watching. Bottom Line: Global investors would be blindsided if a sudden explosion of Sino-Japanese tensions prevented any US-China thaw and confirmed their worst fears about China’s economic decoupling from the West. Investment Takeaways This exercise in identifying black swans may be useful in at least one way: it exposes the vulnerability of financial markets to a sudden reversal of the US dollar’s weakening trend (Chart 16). The dollar would surge on broad Russian instability, Sino-Japanese conflict, or another exogenous geopolitical shock. This kind of dollar surprise would be much greater than a temporary counter-trend bounce, which our Foreign Exchange Strategist Chester Ntonifor fully expects. It would upset the financial community’s dollar-bearish consensus, with far-reaching ramifications for the global economy and financial markets. A rising dollar against the backdrop of a recovering global economy represents a de facto tightening of global financial conditions. Equity markets, for example, have only started to rotate away from the US and this trend would be reversed (Chart 17). Whereas further appreciation of the euro and the renminbi is not only expected but would support global reflation. Chart 16The USD Over Trump's Four Years The USD Over Trump's Four Years The USD Over Trump's Four Years Chart 17Global Market Cap Over Trump's Four Years Global Market Cap Over Trump's Four Years Global Market Cap Over Trump's Four Years There is a much plainer and straighter way to an upset of the dollar-bearish consensus. Rather than a black swan it is a “gray rhino,” the term that Michele Wucker uses for risks that are common, expected, and staring you right in the face.6 This would be the peak of China’s stimulus, which holds out the risk of a major reversal to the pro-cyclical global financial market rally in late 2021 (Chart 18). Chart 18China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched It would be a colossal error if Beijing over-tightened monetary and fiscal policy in 2021 in the context of high debt, deflation, and unemployment (Chart 19). Chart 19Three Reasons China Will Avoid Over-Tightening (If It Can) Three Reasons China Will Avoid Over-Tightening (If It Can) Three Reasons China Will Avoid Over-Tightening (If It Can) Nevertheless the government’s renewed efforts to contain asset bubbles and credit excesses clearly increase the risk. Financial policy tightening is always a risky endeavor, as global policymakers routinely discover. Chart 20Book Profits But Stay Cyclically Positive On Reflation Trades Book Profits But Stay Cyclically Positive On Reflation Trades Book Profits But Stay Cyclically Positive On Reflation Trades We maintain that China’s major stimulus will have a lingering positive effects for the economy for most of this year and that the authorities will relax policy and regulation as needed to secure the recovery. The Central Economic Work Conference in December suggested that the Politburo still views downside economic risks as the most important. But this is a clear and present risk that will have to be monitored closely. Clearly the global reflation trend has extended to dangerous technical extremes over the past month on the realization that US fiscal stimulus will surprise to the upside. Therefore we are doing some housekeeping. We will book 31.1% profit on long cyber security, 16.7% on long US infrastructure, and 24.3% on long US materials. We will also book 9.5% gains on our long EM-ex-China equity trade, which has gone vertical (Chart 20).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Such epidemiologists include Michael Osterholm and Lawrence Brilliant. For Pinker and Rees, see George Eaton, "Steven Pinker interview: How does a liberal optimist handle a pandemic?" The New Statesman, July 22, 2020, newstatesman.com. 2 Thomas Grove, "New Russian Security Force Will Answer To Vladimir Putin," Wall Street Journal, April 24, 2016, wsj.com. 3 Elaine Ganley, "Grisly beheading of teacher in terror attack rattles France," Associated Press, October 16, 2020, apnews.com. 4 Philip Oltermann, "German politician elected with help from far right to step down," The Guardian, February 6, 2020, theguardian.com. 5 Ju-min Park, "Japan official, calling Taiwan ‘red line,’ urges Biden to ‘be strong,’" Reuters, December 25, 2020, reuters.com. 6 See www.wucker.com.

Highlights Rising commodity prices and a weaker dollar will lead to higher inflation at the consumer level beginning this year. In the real economy, tighter commodity fundamentals – restrained supply growth, increasing demand, and falling inventories in oil, metals and grain markets – will push prices higher, which will feed US CPI inflation and inflation expectations going forward. Stronger fiscal stimulus, and the expanding budget deficits that will accompany it – along with the Fed’s oft-affirmed willingness to accommodate them – will allow the USD to resume its bear market, and will also boost commodity prices. Policy support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. Increasing inflation expectations will be evident in longer-dated CPI swaps markets used by traders, portfolio and pension-fund managers to manage longer-term inflation risks (Chart of the Week). Risks remain elevated to the upside and downside: Fundamentals and policy are supportive; public-health risks are acute, and political risk is elevated, particularly in the US, where tensions remain high following the assault on the Capitol in Washington. Feature In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. The real economy and financial markets are pointing to higher inflation going forward. This will become apparent in the longer-term US CPI swaps markets used by traders, portfolio and pension managers as commodity prices continue to rise and the USD resumes its bear market.1 In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. Production-management in the oil market is keeping the rate of growth in supply below that of demand, a trend we expect will continue this year. In the copper market, demand growth will outstrip supply growth this year and next (Chart 2). As a result, both markets will see physical supply deficits this year. Chart of the WeekReal And Financial Markets Point To Higher Inflation Real And Financial Markets Point To Higher Inflation Real And Financial Markets Point To Higher Inflation Chart 2Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. Policy support is helping to maintain commodity demand globally. Fiscal policy worldwide continues to be supportive. In the US, it likely will become even more expansionary, following the electoral wins of Democrats in Senate run-off elections last week, which will bolster president-elect Joe Biden's position in stimulus-package negotiations after he takes office next week. This expansion of fiscal stimulus will dwarf the levels seen in the wake of the Global Financial Crisis (GFC) in 2008-09 (Chart 3). This fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. This continued policy support will lead to a resumption of the USD bear market, following a brief dead-cat bounce over the past few days. This will support demand by lowering the local-currency costs of dollar-denominated commodities, and restrict supply growth at the margin by raising the local-currency cost of production. Chart 3Massive US Fiscal Stimulus Will Grow Higher Inflation On The Way Higher Inflation On The Way Real Economy Will Boost Inflation Expectations Global fiscal and monetary policy support will further energize the rebound in industrial activity and trade globally. This will keep the rate of growth in commodity demand generally above that of supply, and keep prices elevated. The top panel in the Chart of the Week shows the relationship between CPI 5-year/5-year (5y5y) swaps and crude oil and copper prices, price indexes like the DJ UBS commodity index and the S&P GSCI index, and EM trade volumes in the post-GFC period (2010 to now). The curve in the top panel shows the average of single-equation regressions that use these variables as to estimate CPI 5y5y swap rates; the average coefficient of determination for these equations is just below 0.81, meaning these real variables explain ~ 81% of the level of the CPI 5y5y swaps level post-GFC. This also illustrates how prices and activity in the real economy feed into inflation expectations, which we have demonstrated in the past.2 There also is a correspondence between our measures of real activity – i.e., BCA’s Global Industrial Activity index, Global Commodity Factor and EM Commodity-Demand Nowcast – and CPI 5y5y swaps can be seen in Chart 4. These gauges are more heavily weighted to industrial, manufacturing and trade activity than the commodity indexes, and have an average correlation of ~51% with the level of CPI 5y5y swaps. These series are not as highly correlated with CPI 5y5y swaps as the real and financial variables we used above, but they are, nonetheless, useful indicators to track. Chart 4Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Financial Markets Point To Higher CPI Swaps The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficit strongly supports a weaker-dollar view. The bottom panel in the Chart of the Week shows the average of single-equation estimates that use dollar-related financial variables as regressors against CPI 5y5y swap rates – i.e., the USD broad trade-weighted index, the DXY index, and DM financial-conditions index; the average coefficient of determination for these equations is just below 0.83, meaning these financial variables explain ~ 83% of the CPI 5y5y swaps levels. The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficits strongly supports a weaker-dollar view, which also will boost commodity prices and feed into the CPI swaps market. This fiscal and monetary support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. As CPI swaps rates continue to move higher, longer-maturity TIPS breakevens will follow suit (Chart 5). We remain strategically long TIPS versus nominal US Treasuries. We remain strategically long TIPS. Chart 5Expect TIPS Breakevens To Stay Well Bid Expect TIPS Breakevens To Stay Well Bid Expect TIPS Breakevens To Stay Well Bid Risks Remain Elevated CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While fundamentals and policy continue to be supportive – and jibe with our longer-term view that industrial commodity prices will move higher – downside risks remain acute. On the health front, COVID-19 pandemic risks remain high, with public-health officials now warning the risk of a more contagious variant of the virus that emerged in the UK could become the dominant strain by March. Public health officials are considering expanded lockdowns to contain the spread of this strain, which reportedly is 50% to 74% more transmissible, according to the MIT Technology Review.3 Fed policy remains supportive of markets in general and commodities in particular. However, with officials offering conflicting views on the policy stance going forward – specifically re the need to taper sooner rather than later – uncertainty around monetary policy will remain a near-constant feature of the market. Lastly, short-term political risk is elevated, particularly in the US, where tensions are high going into the second impeachment of US President Donald J. Trump, following the assault on the US Capitol. This is an evolving story we will be following closely. Bottom Line: CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While risks remain elevated, we expect policy risks to be managed and for organic growth to pick up going into 2H21.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent prices reached an 10-month high on Tuesday at close to $57/bbl. Saudi Arabia’s surprise cuts will offset the slowdown in demand growth caused by renewed lockdowns in most DM countries, which is expected to be most pronounced in 1Q21. Consequently, in its most recent forecast, the EIA revised its demand estimate for OECD demand by -450k b/d on average in 2021. Separately, cold weather in Asia, combined with supply and shipping constraints, pushed JKM LNG prices close to $20/MMBtu earlier this week (Chart 6). The cold wave will push storage in Europe lower ahead of the summer injection season, as LNG cargoes are redirected towards Asia to meet higher space-heating demand. Base Metals: Bullish Chinese imports of metallurgical coal from Australia fell to 447.5k MT in December, the lowest level since January 2015, when Refinitiv, a Reuters data and analytics service, started tracking them. Met coal imports peaked last year in June 2020 at 9.6mm MT, according to reuters.com. The proximate cause of this collapse is the Chinese retaliation to Australia’s call for an investigation into the source of the COVID-19 pandemic. China’s imports from Indonesia have surged, while India’s imports from Australia have picked up much of the loss in Chinese demand, Reuters notes. Precious Metals: Bullish Gold prices fell by $78/oz to $1,834/oz on Friday – a 2-week low – following Democrats win in run-off elections that gave them both of Georgia’s Senate seats last week. The decline in gold prices largely reflects the rise in US real rates, which rose following an increase in US nominal rates that was not accompanied by higher inflation reports in the short term (Chart 7). Going forward, we expect investors will increasingly focus on inflation risks as fiscal policy in the US expands. Democrats will be able to provide extra COVID relief – increasing monthly income-support payments to individuals to $2,000 from $600 – in a reconciliation bill in 2021. This will pressure real rates down as inflation expectations steadily move higher. Ags/Softs: Neutral In its global supply-demand estimates released earlier this week, the USDA lowered its global grain and soybean production and yields forecasts, which pushed prices sharply higher. CME spot corn prices held sharp price gains, which sent futures limit up Tuesday, on the back of lower production and yields. Soybean and wheat futures also responded to reduced supply estimates in the wake of the WASDE release. Chart 6DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES Chart 7TIGHTENING MARKETS PUSH UP LNG PRICES TIGHTENING MARKETS PUSH UP LNG PRICES TIGHTENING MARKETS PUSH UP LNG PRICES   Footnotes 1 We focus on US CPI swaps because they are responsive to the perceived stance of US monetary policy, even if the Fed’s preferred inflation gauge is the PCE deflator and not the CPI. US monetary policy has a strong bearing on the trajectory of US interest rates and the USD, which impacts commodity prices directly. Please see Treasury Inflation-Protected Securities (TIPS), posted by the US Treasury, which notes: TIPS “provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A fixed interest payment, which changes as the CPI changes, is made twice a year. 2 See, e.g., Trade And Commodity Data Point To Higher Inflation, which we published 27 July 2017. Our approach – i.e., treating inflation expectations as a function of global real variables and financial variables – is consistent with that of the Bank for International Settlements (BIS), which is described in Has globalization changed the inflation process?, posted 4 July 2019. We treat the events of the GFC and central banks’ responses to them as a regime change. In our modeling we estimate dynamic OLS and ARDL equations, to ensure we are modeling cointegrated systems. The average of the coefficients of determination estimated using real variables in DOLS models is pulled lower by the model using COMEX copper futures as an explanatory variable. 3 Please see We may have only weeks to act before a variant coronavirus dominates the US published by the MIT Technology Review 13 January 2021.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.

Highlights OPEC 2.0 output will fall 850k b/d, following a surprise production cut of 1mm b/d by Saudi Arabia announced after two days of OPEC 2.0 meetings.   Russia and Kazakhstan will be allowed to increase production by 75k b/d. More than 70% of producers in the Permian Basin are using an average WTI price of $44/bbl in capex planning, which, if maintained, will restrain US oil output. On the demand side, rising COVID-19 infection, hospitalization and death rates are prompting lockdowns that will restrain oil consumption (Chart of the Week).  However, fiscal support for households will keep consumer spending from collapsing. USD weakness will continue, in line with our expectations, and will support the rally in oil prices. We believe the balance of price risks remains to the upside:  Vaccination rates will increase.  Despite rising COVID-19-induced demand destruction in DM economies, consumption in Asia will continue to recover in 1H21.  OPEC 2.0 will continue to match output to consumption.  Our average Brent forecast for 2021 remains at $63/bbl. The average return on open and closed commodity recommendations at the end of 2020 was -48%, bringing our average return over the past five years to +32%.  Feature The Kingdom of Saudi Arabia (KSA) surprised markets earlier this week with its announcement it will unilaterally cut 1mm b/d of its production in February and March, allowing Russia and Kazakhstan to lift output by 75k b/d in February and by another 75k b/d in March. This will take KSA’s production to ~ 8.1mm b/d, and reduce OPEC 2.0’s production by 850k b/d by March. Prior to Tuesday’s announcement, markets were concerned the inability of KSA and Russia, OPEC 2.0’s putative leaders, to quickly agree production levels against a backdrop of rising COVID-19 infection, hospitalization and death rates signaled the coalition was once again fraying, as it did briefly last year. In March 2020, when the extent of the demand destruction the COVID-19 pandemic could cause was emerging, Russia announced it would not agree to an extension of production cuts then in place at an OPEC 2.0 meeting in Vienna. While the ultimate target of this strategy likely was US shale-oil producers, the declaration prompted KSA to flood oil markets by surging its production and drawing inventories. This exacerbated the COVID-19-induced price collapse in Brent and the KSA and Russian benchmark-crude differentials – Saudi Light and Urals –swelled inventories globally (Chart 2). Chart Of The WeekCOVID-19 Infections, Deaths Will Continue To Hamper Demand KSA Output Cut, Weak Dollar Support Oil KSA Output Cut, Weak Dollar Support Oil Chart 2OPEC 2.0 Unity Is Key To Our View Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Fraying? Our maintained global oil-supply hypothesis is underpinned by the cohesion of OPEC 2.0’s production discipline. Challenges to OPEC 2.0’s shared sense of purpose in the form of disarray within the coalition undermine our supply assumptions, and, perforce, our price forecast. However, an ancillary feature of this hypothesis is supported by apparent disarray within OPEC 2.0: Reminding global oil markets member states are eager to monetize production being held in reserve – i.e., some 7mm b/d of spare capacity, and millions of barrels of low-cost reserves that can quickly be brought to market – serves the coalition’s interest in disincentivizing capital markets from funding production outside the borders of member states. In our view, OPEC 2.0 is targeting an oil-price level – $65/bbl for Brent on average over the next five years – to rebuild member states’ fiscal accounts, and to fund the diversification away from oil-export revenue dependence (Chart 3). It will use current production, spare capacity and inventories to meet increasing demand before producers outside the coalition – chiefly US shale producers – are able to, and keep prices in a range that meets its price target (Chart 4). Chart 3OPEC 2.0 Is Targeting Brent Above USD60 Per Barrel Over 2021-25 OPEC 2.0 Is Targeting Brent Above USD60 Per Barrel Over 2021-25 OPEC 2.0 Is Targeting Brent Above USD60 Per Barrel Over 2021-25 Chart 4OPEC 2.0 Production Will Respond Quickly To Demand Changes OPEC 2.0 Production Will Respond Quickly To Demand Changes OPEC 2.0 Production Will Respond Quickly To Demand Changes The ultimate goal is to maintain the rate of growth in production below that of consumption globally, producing physical deficits (Chart 5). This will force inventories to draw to cover these deficits (Chart 6), which, in turn, will backwardate forward oil-price curves (Chart 7). Chart 5OPEC 2.0 Will Keep Production Below Consumption... OPEC 2.0 Will Keep Production Below Consumption... OPEC 2.0 Will Keep Production Below Consumption... Chart 6...To Draw Down Inventories... ...To Draw Down Inventories... ...To Draw Down Inventories... Chart 7...And Backwardate Oil Forward Curves ...And Backwardate Oil Forward Curves ...And Backwardate Oil Forward Curves US Producers’ Capex Reflects Lower WTI Assumptions By backwardating forward curves, OPEC 2.0 member states will realize higher prices on oil sold into spot markets, while producers outside the coalition hedging production revenues forward will realize lower prices, which will limit the volumes they can bring to market. Ultimately, this will increase OPEC 2.0’s market share, and give it control of global oil-pricing dynamics. Chart 8US Shale Capex Decisions Reflect Lower WTI Price Assumptions KSA Output Cut, Weak Dollar Support Oil KSA Output Cut, Weak Dollar Support Oil US oil producers already are using a lower price deck than implied by the WTI forward curve – $44/bbl, according to the Dallas Fed’s year-end 2020 survey of producers and oil-service companies operating in its district, which includes the prolific Permian Basin (Chart 8). This may reflect the lower willingness of banks to fund their drilling operations, and the evolving backwardation in the WTI market, where the marginal shale-oil producer hedges. If this lower price deck is maintained, we would expect Exploration + Production activities to remain anemic in the US shales. Renewed Lockdowns Could Delay Demand Recovery Health officials in the US, UK, Germany and Japan are renewing lockdowns as COVID-19 infections, hospitalizations and death soar, which likely will reduce oil demand in the short-term until vaccine distribution and inoculation rates increase. In our base case, we see EM oil demand, proxied by non-OECD consumption, recovering to pre-COVID-19 levels by the end of this year with DM demand remaining subdued (Chart 9). Continued USD weakness will continue to support commodity demand, particularly in EM economies (Chart 10). Chart 9Demand Recovery Could Be Delayed By Renewed Lockdowns Demand Recovery Could Be Delayed By Renewed Lockdowns Demand Recovery Could Be Delayed By Renewed Lockdowns Chart 10Weaker USD Will Support Demand Weaker USD Will Support Demand Weaker USD Will Support Demand We will be updating our demand and supply estimates in a couple of weeks, as new data becomes available from the leading energy statistics providers. It is important to note that OPEC 2.0 has been consistently reducing output as realized and anticipated demand has been lowered over the course of the COVID-19 pandemic. We expect this supply-side response to weakening demand to continue. Indeed, KSA’s surprise production cut supports our dominant-supplier hypothesis targeting a price level by adjusting output to meet demand. 2020 Recommendations Down 48% Our failure to close out oil positions in 1Q20 dependent on continued OPEC 2.0 production discipline and improving demand cost us dearly. Our crude oil backwardation trades, in particular, suffered from this and dragged returns on our overall recommendations sharply lower at the beginning of the year (see trade summaries on p.11). On the plus side, our open trades at the end of 2020 continue to perform well, and closed the year up 23%. This can be attributed to OPEC 2.0 production discipline, improving oil demand and the global economic recovery – particularly in Asia’s EM economies, led by China, which lifted oil and metals prices. Net, the average return of our closed and open positions at year-end was -48%. This brings the average five-year return to +32%. The key take-away from this experience is this: Stop-losses are critical on positions that are working, as is strict discipline to cut positions that are not working based on hard stop-losses. Bottom Line: We continue to expect Brent prices to average $63/bbl this year, as OPEC 2.0 continues to calibrate production to demand – both on the downside and the upside. We are expecting DM lockdowns to further reduce realized and expected demand over the short term, which will be countered by lower output from OPEC 2.0. We continue to expect US shale production to fall in 1H21, and to slowly recover. However, that recovery could be delayed if OPEC 2.0 is successful in disincentivizing investment in non-coalition production.   Robert P. Ryan  Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Bullish Brent prices reached a multi-month high on Tuesday following news Saudi Arabia pledged to reduce its production by an additional 1mm b/d in February and March while most other OPEC 2.0 producers keep producing at current quotas. KSA’s cuts come on the back of rapidly rising COVID-19 cases globally and intensifying lockdowns in various regions. OPEC 2.0 is reacting to changes in global oil demand and will continue performing a careful balancing act over 1Q21. We expect oil prices to move up going into 2H21 as wider vaccine distribution begins to slow the spread of the virus. The backwardation in oil market deepened following the announcement (Chart 11). Base Metals: Bullish Already-tight copper markets are getting tighter in the wake of a three-week roadblock in Peru, which has blocked the export of close to 190k MT of copper concentrate, according to mining.com. Production at the Las Bambas mine could halt production entirely, according to local officials. Should that occur, 2% of global mine production would be removed from the market. We are forecasting a physical deficit in 2021-22, on the back of inadequate mining capex and falling ore quality. We expect inventories will continue to draw as consumption increases amid stagnant output (Chart 12). Precious Metals: Bullish As we go to press, Democrats won one of the Senate elections in Georgia and appear likely to win the second. Winning both seats has important ramifications for gold prices over the next few years. This increases the odds of larger fiscal stimulus over the short- and medium-term and reduces the risk of premature fiscal tightening. Fiscal and monetary policy need to work in tandem to generate above-target inflation over the next 2-3 years. Larger fiscal spending is important for sustaining strong broad money growth until the private sector fully recovers. Ags/Softs:  Neutral  Argentina’s export ban and continued poor weather conditions are bolstering corn prices, pushing nearby CME corn futures prices to $5/bu earlier this week. A Farm Futures Survey released this week indicated falling yields in the US will accompany lower supplies in Latin America due to dry weather, according to farmfutures.com. Chart 11Backwardation Deepens Following Voluntary Saudi Oil Cuts Backwardation Deepens Following Voluntary Saudi Oil Cuts Backwardation Deepens Following Voluntary Saudi Oil Cuts Chart 12Copper Supply-Demand Balances Point To Growing Deficits Copper Supply-Demand Balances Point To Growing Deficits Copper Supply-Demand Balances Point To Growing Deficits Footnotes Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 2020 Q3 2021 Key Views: Tighter Markets, Higher Prices 2021 Key Views: Tighter Markets, Higher Prices Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Trades Closed KSA Output Cut, Weak Dollar Support Oil KSA Output Cut, Weak Dollar Support Oil