Currencies

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

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

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Rates Are Rising Everywhere Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Global Excess Savings Total $3 Trillion Global Excess Savings Total $3 Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Chart 6Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 ...Since This Is As Early As Q3 2021 ...Since This Is As Early As Q3 2021 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing ...With The Possible Exception Of Housing ...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global Economy Chart 18US Growth Already Looks Strong... US Growth Already Looks Strong... US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening China Is Risking Overtightening China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places Financials And Tech: Trading Places Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Stay Long TIPS Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Limited Upside For Oil From Here Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Turning More Positive On Private Equity Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Is Perfection Priced In? Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? China Slowing Again? China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation  

Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite The Global Growth Tax Will Bite The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow Chinese Credit Will Slow Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Deteriorating Surprises Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable Commodities Are Vulnerable Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory.  Chart 5The Greenback's Counter-Cyclicality The Greenback's Counter-Cyclicality The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 The Euro's Short-Term Fair Value Is At 1.1 The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated Speculators Have Not Capitulated Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates EUR/USD And Chinese Rates EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives EUR/USD Will Follow Cyclicals/Defensives EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe Investors Structurally Underweight Europe Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The DEM In The 70s The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13).  Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value EUR/USD Trades Well Below Long-Term Fair Value EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial Conditions Easy European Financial Conditions Easy European Financial Conditions Chart 15Make Room For the Euro! Make Room For the Euro! Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency.  Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16).  This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It Once Was The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things Higher Yields And A stronger Euro, These Are Few Of My Favorite Things Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Fixed Income Performance Government Bonds The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Corporate Bonds The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Equity Performance Major Stock Indices The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Geographic Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Sector Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward  

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

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