Currencies

Highlights US inflation expectations will continue to grind higher as commodity markets tighten, and financial markets price to an ultra-accommodative Fed over the next 2-3 years. The US stock-market rally is reducing equity yields and squeezing equity risk premiums, which acts as a drag on gold prices.  Higher earnings, lower stock prices or both are needed to reduce this effect. Pandemic uncertainty continues to fuel safe-haven demand for the USD, which remains a headwind for gold and silver.  Vaccination availability needs to reach a level that convinces markets global contagion risk has been minimized.  Until then, this remains the dominant downside risk to gold and commodities. The balance of risks continues to favor gold: US real rates will remain weak as the Fed remains behind the inflation-vs-rates curve, and the USD will be pushed lower (Chart of the Week).  We continue to expect gold prices to push to $2,000/oz. We remain bullish silver, and view the recent retail-spec price blip as transitory.  Fundamentally, silver supply growth is weakening, and demand is strengthening as the renewable-energy buildout accelerates and consumer spending revives.  We expect silver's price to trade back to $30/oz.  Feature US inflation expectations will continue to grind higher, as tightening markets for industrial commodities push oil and base metals prices higher (Chart 2).1 As is apparent in Chart 2, these real-economy factors feed directly into five-year inflation expectations, which are important to policy makers and portfolio managers managing risk in trading markets.2 Continued Fed accommodation of massively expansive US fiscal policy also will stoke inflation expectations, and keep real rates negative or weak at low positive levels as realized inflation and inflation expectations increase. These real and financial effects will be positive for gold prices, as the Chart of the Week illustrates. Chart of the WeekRising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Rising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Rising Inflation Expectations vs. Falling Risk Premiums Restrain Gold Chart 2Tightening Commodity Markets Push Inflation Expectations Higher Tightening Commodity Markets Push Inflation Expectations Higher Tightening Commodity Markets Push Inflation Expectations Higher Battling against this tailwind is the historic US equity rally, which has crushed stock yields and the equity risk premium vs bond yields.3 Gold prices are positively correlated with equity risk premiums – the positive economic forces that push dividend yields higher also tend to push gold and commodity prices higher – which means the falling risk premiums are acting as a headwind to gold prices (Chart 3).4 If, as the global economy recovers, the rate of growth in earnings is greater than that of equity prices, stock yields will expand, which will be supportive of gold prices. That said, we do not expect the contraction of the equity risk premium to dominate the evolution of gold prices. Tightening fundamentals in the real economy and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics. Chart 3Falling Stock Yields Pressure Equity Risk Premiums Falling Stock Yields Pressure Equity Risk Premiums Falling Stock Yields Pressure Equity Risk Premiums Balance of Risks Favors Gold Fed policy pronouncements point to continued accommodation of massive fiscal stimulus in the US, with the central bank strongly indicating it will, as a matter of policy, remain behind the inflation-vs-rate-hikes curve for at least another 2-3 years. Taking the Fed at its word, this means US real rates will remain weak, and the USD will be pushed lower as the central bank continues to accommodate higher US budget deficits at the federal level. However, as we have repeatedly noted, the broad trade-weighted USD has found strong support at current levels following a precipitous fall from its COVID-19-induced highs in 1Q20: As pandemic uncertainty feeds into global policy uncertainty, USD safe-haven demand remains elevated (Chart 4).5 While we concentrate on five-year inflation expectations in our modeling, indications of price pressures are showing up in the manufacturing sector in the US (Chart 5), as our colleagues in BCA Research’s US Bond Strategy note in their report this week.6 This confirms that the price strength seen in commodity markets for raw materials used in manufacturing are showing up in the economy as a whole. Chart 4Lower USD, Stronger GDP Bullish For Copper Prices Lower USD, Stronger GDP Bullish For Copper Prices Lower USD, Stronger GDP Bullish For Copper Prices Chart 5Inflation Indicators Hook Up Inflation Indicators Hook Up Inflation Indicators Hook Up Our price target for gold remains $2,000/oz. The sooner vaccines are deployed globally – so that markets can reasonably assign lower odds to a resurgence of COVID-19 and its more insidious variants forcing new lockdowns – the sooner the pandemic uncertainty keeping the USD well bid will dissipate as a fundamental factor restraining a continuation of gold’s rally. Silver Is Not GameStop The Reddit-powered surge in retail silver trading this past week, which lifted silver prices some ~ 11% on Monday to $30/oz, is all but a memory now that the white metal is again pricing in line with fundamentals. We turned bullish silver in July of last year, arguing fundamentals suggested silver could outperform gold in 2H20, which it did.7 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 6). We expect the supply side of the market to remain under pressure this year and the next, given the physical deficits we are forecasting for the copper market over the next two year: The supply side of silver is a function of copper, zinc and lead mine output (i.e., silver largely is a byproduct). On the demand side, continued recovery of consumer spending and the decade-long buildout of renewable-energy generation – which is heavily reliant on copper and silver to a lesser degree – will force prices higher. We remain bullish silver. However, given our expectation its price will trade again to $30/oz, we do not expect any dramatic tightening of the gold/silver ratio this year (Chart 7). Chart 6Silver Market Tightens, Along With Other Commodities Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets Chart 7Expect Gold/Silver Ratio To Continue To Narrow Expect Gold/Silver Ratio To Continue To Narrow Expect Gold/Silver Ratio To Continue To Narrow Bottom Line: Tightening commodity fundamentals and continued monetary accommodation at the Fed will dominate gold- and silver-pricing dynamics this year and the next. The contraction of the equity risk premium will not dominate the evolution of gold prices. At the margin, if earnings growth exceeds  equity-price increases, equity yields will expand, which will support gold prices. We expect gold and silver to trade to $2,000/oz and $30/oz this year – i.e., close to ~ 10% gains for both. Therefore, we do not expect much movement in the gold/silver ratio this year   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0’s Joint Technical Committee (JTC) lowered its estimated demand growth for 2021 to 5.6mm b/d from its 5.9mm b/d estimate last month, at its Tuesday meeting. The JTC also is expecting the oil market to be in a deficit this year, which will, by the Committee’s estimate, peak at 2mm b/d in May 2021, according to reuters.com. This is in line with our maintained hypothesis that the producer coalition led by Saudi Arabia and Russia will continue to calibrate production in line with demand to keep global storage levels drawing. The JTC was not expected to recommend any change in production policy to oil ministers on Wednesday when they met. We expect OECD oil inventories to hit their rolling five-year average in 1H21, largely because of OPEC 2.0’s production discipline and production losses outside the coalition (Chart 8). Base Metals: Bullish Battery-grade lithium carbonate soared 40% y/y in January in China to $9,450/MT, according to mining.com. The reporting service noted strong demand for lithium iron phosphate (LFP) batteries used to power subsidized short-range autos, public transport infrastructure electrification, and power generation. Precious Metals: Bullish COVID-19-induced demand destruction pushed gold demand down 14% y/y in 2020, to just under 3,760 tons, according to the World Gold Council’s 2020 supply-demand tallies.  At 4,633 tons, gold supply lost 4% y/y, the most since 2013, according to the WGC.  Supplies were disrupted by COVID-19 as well.   (Chart 9). Ags/Softs: Neutral Despite poor weather conditions in South America, US farmers are beginning to worry about record or near-record crops in the current growing season, according to farmprogress.com. grains are trading lower following recent rallies on concerns the upcoming harvest could be better than expected. Tomorrow’s USDA WASDE report will be eagerly awaited for the Department’s latest assessments. Chart 8OPEC 2.0 Keeps Supply Growth Below Demand Growth OPEC 2.0 Keeps Supply Growth Below Demand Growth OPEC 2.0 Keeps Supply Growth Below Demand Growth Chart 9Gold Below 200 Day Moving Average Gold Below 200 Day Moving Average Gold Below 200 Day Moving Average     Footnotes 1     Our most recent reports on copper and oil prices – Copper's Supply Challenges and Brent Forecast: $63 This Year, $71 Next Year published 10 December 2020 and 21 January 2021 – highlight the tightening of industrial-commodity markets globally. 2     While we do find strong relationships between gold prices and 5- and 10-year US real rates, we do not find any relationship with the slope of the US rates forward curve. 3    For a discussion of equity risk premiums, please see Asness, Clifford S. (2000) “Stocks versus Bonds: Explaining the Equity Risk Premium.” Financial Analysts Journal. March/April 2000: pp. 96-113. 4    In the post-GFC period 2010-2020, the S&P 500 equity risk premium is borderline insignificant in a cointegrating regression that includes other real and financial variables (i.e., copper prices, US Fed Funds, and global economic policy uncertainty). We therefore to not treat it as determinant to the evolution of gold prices in the same way as the real and financial variables we use as regressors. 5    We expect this pandemic uncertainty to break, but not until markets are convinced sufficient supplies of vaccines will be available globally to control COVID-19 infections, hospitalizations and deaths. Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, which we published last week, for further discussion. It is available at ces.bcaresearch.com. 6    For the first time 2011, the Prices Paid component in last month’s ISM Manufacturing PMI came in above 80, signaling for the first time since 2011. Please see No Tightening In 2021, published by BCA’s US Bond Strategy 2 February 2021. It is available at usbs.bcaresearch.com. 7     Please see Silver Likely Outperforms Gold In 2H20, which we published 2 July 2020. It is available at ces.bcaresearch.com. We recommended a long silver position then at $18.51/oz and closed it 23 September 2020 at $26/oz. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights We are hesitant to call a top to the volatility spike just yet. The US dollar is experiencing a counter-trend bounce. We also see political and geopolitical risks flashing yellow. House Democrats are drafting a reconciliation bill that will remind financial markets of looming tax hikes. President Biden faces imminent tests on China/Taiwan and Iran. The tech sector has bounced amid the setback to the reflation trade. Over the long run the Biden administration’s reflationary agenda suggests tech will no longer outperform. Biden’s regulatory risk to the tech sector is not immediate but still a downside risk. No major piece of bipartisan legislation is forthcoming but the Department of Justice, FCC, and FTC can bring negative surprises. We are hitting pause on our S&P trades until Biden passes some early hurdles. Feature Volatility has room to run, judging by past post-crisis periods (Chart 1), and this time we are especially concerned with brewing geopolitical risks, namely the US-China tensions over the Taiwan Strait. This geopolitical risk comes on top of the short squeezes and battles that retail investors are having against hedge funds all over the market. China is reminding the world of its red line against Taiwanese independence while testing the newly seated Joe Biden administration over whether it will seek a technological blockade against the mainland. Economic and trade policy uncertainty have collapsed but they would surge in the event of a crisis incident (Chart 2). While war is not likely, it is possible, so we need to see the Biden administration defuse the situation and pass this first test before we are willing to take on more risk on a tactical three-to-six-month time frame. Chart 1Volatility Can Go Higher Still Volatility Can Go Higher Still Volatility Can Go Higher Still Chart 2Uncertainty Down But Beijing Testing Biden Uncertainty Down But Beijing Testing Biden Uncertainty Down But Beijing Testing Biden Chart 3Biden's Approval Starts At 55% Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same President Biden’s average approval rating in his first two weeks in office is 55%, right where former President Trump’s disapproval rating would have suggested (Chart 3). This is a significant but not extravagant improvement in political capital for the White House. Our Political Capital Index shows Biden’s position as moderate-to-strong (Table 1). Table 1Biden’s Political Capital Moderate-To-Strong Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same The implication is that he still has a chance of passing his $1.9 trillion American Rescue Plan as a bipartisan bill with 10 Republican senators, a feat that would likely lower the topline value to around $1.3 trillion (Republicans proposed $618 billion) and exclude an increase in the federal minimum wage to $15 per hour. There is also a strong swing of independents in favor of Democrats in the opinion polling, in the wake of the incident on Capitol Hill on January 6, despite the fact that Republican and Democratic party identification are both stuck at around 30% — meaning that the Biden administration does have something to gain by appearing bipartisan (Chart 4).1 Republicans might cooperate to staunch the bleeding of their own support. Even Republicans approve of stimulus amid the pandemic and they would later be able to oppose Biden’s more controversial proposals with better optics having demonstrated bipartisan intent at the outset. However, House Democrats are already proceeding with a budget resolution, the first step in the budget reconciliation process that enables them to bypass Republicans entirely and get almost everything they want (Diagram 1). Chart 4Will Independents Keep Breaking Toward Democrats? Will Independents Keep Breaking Toward Democrats? Will Independents Keep Breaking Toward Democrats? Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Biden’s political capital should strengthen over the next year as the vaccine rollout improves and the economy comes roaring back. Official economic projections suggest that growth will glide solidly above potential until 2026 and that the output gap will close by 2024 (Chart 5). These estimates will be disappointed in various ways, of course, but in the near-term the risk is to the upside as they do not include Biden’s proposed $1.9 trillion rescue plan or his remaining, post-COVID agenda afterwards, which could cost anywhere from $3.7-$6.4 trillion over a ten-year period.2 The economy will be at less risk of relapsing than of overheating. This is especially true given the Federal Reserve’s new average inflation targeting strategy, which will discourage rate hikes till next year at the very earliest (and, from a political point of view, we would think 2023). Looking at the chart, Biden’s economic backdrop is far more propitious than that of his former boss Barack Obama’s back in 2009. Biden’s political momentum is therefore sustainable when it comes to the two budget reconciliation bills he wants to pass this year and next year. Republican internal divisions will help him. These were highlighted this week by Republican National Committee Chair Ronna McDaniel’s criticism of former New York Mayor Rudy Giuliani’s claims of voter fraud after the election and Senate Minority Leader Mitch McConnell’s recent scathing criticism of controversial pro-Trump freshman House member Marjorie Taylor Greene of Georgia. Republicans are only beginning their internal struggle and it is not certain that it will be resolved in time for the 2022 midterm elections. This is another reason to think that Biden’s political capital will be sustained and that moderate Republicans might assist with some Democratic legislation. The risks to Biden’s momentum stem from foreign policy (China, Iran, Russia), rapidly emerging financial instability, his party’s attempts at social control, and any major (not minor) negative developments involving the still-running pandemic and vaccine rollout. Chart 5US Economic Outlook Over Biden’s Term Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Macro Reflation Says Stay Underweight Tech The tech sector experienced a manic phase last year when COVID-19 struck and lockdowns kept consumers at home with nothing to do but work, shop, and stare at their phones. The big five companies – Apple, Microsoft, Google, Amazon, and Facebook – together witnessed an extraordinary run up relative to the other 495 companies in the S&P index that has since peaked and dropped off (Chart 6). Chart 6Fade The Big Tech Bounce Over Long Run Fade The Big Tech Bounce Over Long Run Fade The Big Tech Bounce Over Long Run Tech stock market capitalization accounts for 34% of American economic output – an extreme sign of over-concentration at a time when the market is generally inflated, according to the Buffett Index of stock market cap relative to GDP (Chart 7). Tech outperformance rests on strong earnings growth – supercharged due to the COVID crisis – as well as the secular fall in bond yields as a result of the global backdrop of excessive savings, low inflation, and scarce growth. Tech stocks are especially sensitive to bond yields because markets are projecting their earnings far into the future, as our colleague Mathieu Savary explained back in August. Ultra-dovish monetary policy with zero interest rates for longer and longer time frames is a perennial gift to these companies (Chart 8). Chart 7Buffett Indicator Says Big Tech Too Big Buffet Indicator Says Big Tech Too Big Buffet Indicator Says Big Tech Too Big Chart 8Big Tech Maxing Out As Bond Yields Rise? Big Tech Maxing Out As Bond Yields Rise? Big Tech Maxing Out As Bond Yields Rise? The catch is when and if growth and inflation expectations pick up. Even during the Dotcom bubble in the 1990s, the tech sector could not withstand rising interest rates (Chart 9). Eventually higher inflation will translate into central bank hikes and rising real interest rates – which should be very bad for tech as future cash flows lose value. Rising rates increase the cost of capital, while cyclical industries perform better in high growth environments with rising commodity prices. A recovery of inflation is becoming a more visible risk to investors over the coming few years. Even though unemployment is still elevated, and the output gap negative, the sea change in fiscal policy is likely to close this gap quickly and put upward pressure on expectations and prices. It will still take time to close the gap but each new dose of government spending on top of what is needed to plug the gap in demand due to the pandemic-stricken service sector will accelerate the time frame in which the labor market will tighten and price pressure will return. Investors are increasingly wary of this inflation risk as it is the logical consequence of the new combination of extreme monetary and fiscal accommodation. Earnings in the tech sector relative to the rest of the market have also peaked – and did not exceed their previous high point in 2010 despite the uniquely favorable backdrop (Chart 10). The big five have nearly saturated a lot of markets which raises the possibility that if the policy backdrop darkens, then they will see earnings disappointments. The Biden administration’s plan to raise the corporate tax rate to 28% and impose a 15% minimum tax on company book income would come as a double whammy for tech earnings, as they are relatively more exposed to increases in effective tax rates than other sectors. Chart 9Big Tech Wants Deflation, Big Government Wants Reflation Big Tech Wants Deflation, Big Government Wants Reflation Big Tech Wants Deflation, Big Government Wants Reflation Chart 10Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Finally, there is the long building problem of regulatory risk, as Americans have clearly become more concerned about Big Tech’s power and influence over their daily lives and politics. Here we do not think the Biden administration poses an immediate threat of frontal legislative assault, but we do think the end game is greater regulation, including tougher enforcement from antitrust agencies. Combined with geopolitical risk from Europe and other countries also seeking to tax and regulate these companies, the recent global semiconductor shortage, and the potential for a Taiwanese tech blockade, the political risk is clearly to the downside. Bottom Line: The macro backdrop has darkened for the tech sector. With governments turning more reflationary via a sea change in fiscal policy on top of ultra-easy monetary policy, inflation expectations should recover and inflation-sensitive sectors like tech should underperform. This risk is clear despite the fact that inflation requires the labor market to heal first. Any political, geopolitical, or regulatory risks would only further undermine the case for tech sector outperformance. Tech, Polarization, And Disinflation A critical question for investors is the relationship between US political polarization, the tech sector, and the disinflationary macroeconomic context that has proven so beneficial for Big Tech’s stock market performance. If polarization leads to gridlock, austerity, and disinflation, then tech can continue to enjoy the policy environment. But if polarization subsides, or if it coexists with a reflationary backdrop – as is the case today – then tech faces a new risk. It is fair to hypothesize that the rise of Silicon Valley and especially of social media has something to do with the explosion in US polarization over the past three decades. A simple chart of the S&P 500 alongside our polarization proxy – which measures the difference in presidential approval based on party – suggests that polarization could have some connection with tech sector outperformance (Chart 11). This is not a coincidence but the causality may work differently than some assume. The first period of tech sector outperformance, which rested on the “peace dividend” period of hyper-globalization, strong growth, strong dollar, low inflation, and technical innovation, occurred during the explosion of US polarization in the wake of the Cold War, when the US’s common enemy fell and the country’s political parties turned to do battle with each other for global supremacy. The structural changes of Reaganomics and NAFTA coincided with the political battles of the Republican revolution of 1994 and Bill Clinton’s sex scandal and impeachment. This heady period came to a peak in 2000 when the dotcom bubble burst and the US suffered its first contested election since 1876. Essentially globalization led to a deflationary backdrop that favored tech but also triggered the political struggle within the US for the spoils of victory in the Cold War. Chart 11Big Tech Likes Polarization And Gridlock Big Tech Likes Polarization And Gridlock Big Tech Likes Polarization And Gridlock The second period of tech sector outperformance emerged from the Great Recession, still higher wealth inequality, and the slow-burn economic recovery of the 2010s. The disinflationary environment and dollar bull market proved beneficial to the tech companies. In this case globalization’s deflationary effects continued but were compounded with US household deleveraging, which was far more malicious for the American middle class. Crucially, polarization created gridlock in Congress from 2010, preventing the US from pursuing a robust fiscal policy in the wake of the crisis that might have led to a more rapid recovery. Instead an extended disinflationary environment fed into social unrest and populism. While public animus naturally turned against Wall Street and the Big Banks in the wake of the financial crisis, the Dodd-Frank financial reform helped to pacify the public’s anger (though not entirely – and financial regulation is gradually reemerging as a relevant political risk). As the financial crisis faded from memory, but the low-growth, disinflationary environment continued to take a toll on households, an angry electorate began to freely express itself in the digital realm. Tech companies were happy to ride this wave and outperformed other sectors. As the backlash continued mounting, tech companies failed to rein in the angry userbase they had cultivated, and now they are staring at massive regulatory and legal risks from policymakers. Both Barack Obama and Donald Trump used Twitter and social media as a tool to establish direct engagement with their political base, much as Franklin Delano Roosevelt had used the radio and the fireside chat. This rising political heft ultimately made the companies conspicuous as conservatives blamed them for supporting the Obama administration (and Clinton campaign) while liberals especially blamed them for getting Trump elected. The Trump saga in particular gave rise to the so-called “tech-lash,” or backlash, as the companies’ core base of young, urbanized, cosmopolitan, and international users called on the tech companies to stop the spread of Russian propaganda, or other propaganda they disagreed with, and undertake socially progressive causes. Meanwhile the older, conservative, and rural population doubted that Russian interference caused the 2016 election result and sensed that the tech companies’ content moderators might not be all that scrupulous regarding the difference between conservative views and Russian information warfare (Chart 12, top panel). In combination with the heated election year campaigning, the pandemic and the backlash against lockdown, tension in the virtual world came to a peak last year and spilled out into the real world. This all came to a head with Twitter and Facebook first censoring and then banning President Trump from their platforms amid his claims of voter fraud and the riot on Capitol Hill. Chart 12Big Tech Not The Chief Driver Of Polarization Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Two major policy changes have occurred that threaten to reverse this macro backdrop. First, as a result of the 2020 crisis the Democrats won control of the White House and Congress and can now pass their mammoth spending agenda, which goes beyond pandemic relief to expanding the role of government in American economy and society – including by reflating the economy and imposing higher taxes on corporations, both of which threaten to undermine the tech sector’s outperformance. Second, China’s secular slowdown, reduction of trade dependency, and divorce from the US economy have undermined hyper-globalization. The Biden administration is pursuing on-shoring and China restrictions albeit to a lesser extent than its predecessor. If technological advance and social media cause political polarization, then these policy shifts may not last long or have a durable macro effect. But technology and communication tools have advanced throughout history regardless of whether polarization in any given country was rising or falling. Older people are the most partisan in the US yet they are the least enthusiastic users of social media (Chart 12, bottom panel). Tech and social media have proliferated across the world and yet polarization has fallen in Germany, Australia, Sweden, and other economies even as it has risen in the United States and arguably the United Kingdom (Chart 13). If social media enabled populist outcomes like Trump and Brexit, then why did populism fall short in France, Spain, Italy, and Germany? Social media participation thrived on the rise of polarization through the 2000s and 2010s but it exacerbated the problem – and once polarization erupted in the form of an anti-establishment presidency, Russian interference, the Cambridge Analytica scandal, and real world riots and social unrest, the tech platforms found themselves in the crosshairs of both of the political factions and the various politicians trying to appease their anger. Silicon Valley and the FAANGs operate in a power struggle – not merely a politicized environment – that is here to stay and will direct their attention away from their primary business and toward paying for lobbyists in Washington, Brussels, and elsewhere. This in itself is a danger to their business models even if it were not the case that the macro and policy backdrop is less supportive. Bottom Line: The reflationary fiscal and policy backdrop will continue in the coming years, a macro headwind for tech outperformance, while political risks to the tech sector have grown substantially. Chart 13Polarization Falls In Many Countries Despite Social Media Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Congress In Check But Regulatory Risk Persists Democrats and Republicans have a different and opposed set of grievances against Big Tech, which is likely to prevent comprehensive legislation from developing anytime soon. But legislation is still possible, and in the meantime risks will come from emboldened regulators. Based on the House judiciary hearing in July 2020, Democrats are concerned with content moderation and market concentration. They want to fortify their recent gains in preventing social media companies from aiding what they regard as the spread of seditious and libelous material or propaganda that favors the anti-establishment Trumpist right wing. Judging by the Senate Republicans’ hearings in October and November 2020, Republicans are primarily concerned with content moderation– i.e. preventing conservatives from being de-platformed, and conservative views from being censored. Republicans are less concerned about market concentration, i.e. accusations of monopolistic and anti-competitive behavior.3 Now that the social media companies have more or less thrown in with the Democrats on content moderation, Democratic priorities are likely to shift to antitrust and anti-competitive behavior. But serious changes would require either abolishing the filibuster in the Senate (which is not happening for the time being due to last month’s bipartisan power-sharing arrangement) or winning over 10 Republicans. This will be difficult, especially when it comes to the Democratic belief that a generational shift in antitrust doctrine and practice is necessary. A frontal assault on the sector would require passing a law that resolves a number of jurisprudential issues so that the courts could be instructed to interpret antitrust issues with a greater focus on rooting out anti-competitive or collusive behavior (as opposed to lowering prices and preventing consumer harm). This is possible but Republican agreement would require major compromises that the Democrats are not inclined to make. A bipartisan bill is still possible because last year’s hearings revealed that there is common ground between the two parties. Both have agreed that anti-trust agencies should be strengthened and empowered to examine Big Tech; that data should be portable and platforms should be interoperable (rather than favoring their own services or imposing penalties for users who would switch services); that mergers and acquisitions should be examined with the presumption that consumers will be harmed, so that the merging parties must show that they cannot otherwise achieve the desired consumer benefits and that their actions will serve some public good; and that regulators need not trouble themselves excessively about the problem of accurately defining the market, which is always a sticking point for such fast evolving services.4 Moreover there is overlap between the populist sides of both parties, comparable to the bipartisan populist demands to give larger household rebates amid the COVID crisis. For example, Democrats want to revise Section 230 of the Communications Decency Act, which protects the tech companies from being held liable for the actions and comments of third parties on their platforms. The Democratic proposal is to break down the distinction between neutral tools and content creation, arguing that tech platforms can be “negligent” and that in order to benefit from the liability protections they should have to demonstrate that they have taken reasonable steps to prevent unlawful misuse of their platforms that cause harm to others. This idea of “reasonable moderation” would leave a very vague standard for judges that would lead to a complex operating environment across different jurisdictions, but it is attractive to Trumpists and right-wing populists who support greater ability to sue the platforms for alleged bias.5 Thus revising Section 230 could create a bridge between the two parties, albeit isolating the free-market contingent in either party. It would foist huge new liabilities not only on the tech giants but also on startups and market entrants with far fewer lawyers. The mechanism will be a decisive feature of any future legislative proposal, however. Republicans are staunchly opposed to creating an Internet oversight committee, similar to the Consumer Financial Protection Bureau, or anything that smacks of Big Brother and would risk too cozy of a relationship between the regulatory state and the immense capabilities of the tech companies. But they could be amenable to law that strengthens the antitrust agencies and alters the parameters of judicial scrutiny if they believed it would make consumer choice and innovation more likely. If popular opinion suggested great urgency on this issue then perhaps the parties’ differences could be resolved more quickly in the form of a major bill. But polls suggest the populace is also divided on tech regulation – in part because the pandemic left consumers largely thankful for the Internet services that they relied on so heavily while under lockdown. A bare majority of conservative Republicans and liberal Democrats now favor tech regulation, the average voter is lukewarm, and moderates of both parties show little enthusiasm (Chart 14). By contrast, at the height of Democratic anxiety over Trump’s election and Russian interference, a clear majority of Democrats and Democrat-leaning independents favored tougher regulation. Chart 14Public Split On Government Regulation Of Big Tech Companies Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same In short, the public is split, the parties are split, and the various 2020 crises have temporarily subsided, so tech regulatory risk will emanate from regulatory authorities but not from major new legislation anytime soon. Regulatory agencies thus threaten to give tech stocks negative surprises – even if the process takes time. Biden will replace one commissioner on the Federal Trade Commission (FTC) immediately but may only be able to replace two Republican commissioners toward the end of his term, in September 2023 and 2024, meaning that the commission will be divided (Table 2). Any major crackdown on market concentration will have to proceed upon bipartisan grounds unless Democrats gain control of this commission sooner. Meanwhile Biden will be able to replace outgoing Republican Ajit Pai on the Federal Communications Commission (FCC) right away, giving a Democratic tilt to this body, which is capable of pursuing the administration’s goals on content regulation (Table 3). Here the Supreme Court may eventually weigh in to defend free speech and press rights, which Section 230 ultimately reinforces, but the tech companies will be in the firing line until then. Table 2Federal Trade Commission Balance Of Power Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Table 3Federal Communications Commission Balance Of Power Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Finally, Biden’s nominee for the US Assistant Attorney General for the antitrust division will be a critical post to watch for the Department of Justice’s involvement in tech regulation and antitrust, though this position requires Senate confirmation, which will rule out any populist candidate. If Biden picks a former Facebook lawyer as rumored then he clearly will not be prioritizing a tough antitrust stance.6 Bottom Line: With the Senate filibuster intact for the time being, Democrats need 10 Republican senators to join them to pass any significant legislation that would amount to a frontal assault on the tech sector. This is possible but not probable in the short run, as Congress prioritizes the fight against the pandemic, Republicans and Democrats remain divided and the public is lukewarm about regulation. Much more likely is a regulatory slow boil at the hands of the DOJ, FCC, FTC, and the states. Biden Maintains Obama Alliance With Silicon Valley Public opinion is wishy washy about Big Tech, as mentioned above. Compare attitudes toward Wall Street and the major pharmaceutical corporations. Opinion shifted against the banks drastically during the financial crisis and has since recovered to about 24% net approval, although there are also polls showing that consumers of all stripes believe the banking sector got off easy and could use more regulation (Chart 15). The health care industry also took a hit during the Great Recession, when laid off workers also lost their health insurance, and has also largely recovered due to its conduct during the pandemic. The exception is Big Pharma, which is widely blamed for excessive drug prices, got bashed under President Trump, and is about to get bashed by President Biden in the form of price caps and Medicare negotiations. By contrast with these sectors, the computer and Internet industry has seen a hit to its popular support since Trump’s election but never dipped into net negative territory and may be recovering due to its helpful role during the COVID lockdowns. When net popular approval turns negative then it will be a flashing red light for the tech sector that sweeping regulation is imminent. While some of the opinion polling is lagging, the crisis over the election is unlikely to produce this effect because the public views break down along partisan lines. Chart 15Big Tech More Popular Than Big Banks, Big Pharma Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Thus unlike the Trumpists, or the populists in the Democratic Party, the Biden administration is only inclined gradually to dial up the pressure on Big Tech. Biden would bite off more than any president could chew if he tackled tech aggressively along with other big corporations. His campaign platform and early executive orders show that he is already tackling Big Health Insurance and Big Oil, sectors that make up 7.5% and 1.4% of GDP respectively. There is at least some focus on re-regulating the financial industry as well (7.7% of value add), albeit with lower priority. To attempt a major overhaul of Big Tech (at least 5.3% of GDP) on top of all this would be impracticable even if Biden were inclined to listen to the anti-monopoly crusaders in his party. Information services are obviously important to the economies of solid blue states like California, New York, and Washington but they are increasingly important to critical swing states like Georgia and Pennsylvania – places where voters will be skeptical of Biden’s policies on energy and immigration. The information sector is growing fastest in blue states and in battlegrounds like Arizona. It employs more people in blue states and in battlegrounds like Georgia. And it is rapidly employing more people in the grand prize of Democratic designs, Texas, where an exodus of Californians fleeing poor governance and high costs holds out the possibility of creating a decisive Democratic ascendancy in the Electoral College. Silicon Valley and other tech clusters will maintain their unique strengths and network effects for a long time but the dispersion of the tech sector to cheaper heartland regions has electoral consequences that mainline Democrats will not want to suppress. Not only did the tech firms help Biden get elected through votes and media controls but also through campaign contributions. The financial and health care industries punished the Democrats for passing the Affordable Care Act (Obamacare) and Dodd-Frank reforms in 2009-12 (Chart 16). By contrast the tech heavily favors Democrats over Republicans (with donations at $170 million versus $20 million in the 2020 election). Biden’s priorities are two budget reconciliation bills that will partially reverse the Trump tax cuts in order to pay for the entrenchment and expansion of Obamacare and other aspects of his health care and child care agenda. He is also focused on infrastructure, particularly green infrastructure and renewables, to create jobs and galvanize the climate change coalition. Broad re-regulation is coming down the pike, but health, immigration, energy, and labor are higher priorities than tech. The tech sector faces greater scrutiny than before, first from the FCC and later from the DOJ and FTC, but the administration will have more room for maneuver later in its term. Bottom Line: The Obama administration forged an alliance with Silicon Valley that Biden will largely maintain. The purpose of regulatory pressure is to build leverage over the tech giants. Chart 16Big Tech A Big Donor To Democratic Party Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Investment Takeaways Not all of the dominoes are lined up to topple Big Tech in a massive display of federal monopoly busting. The public is lukewarm and the political elite are divided. Nevertheless the long-term trajectory points to greater government scrutiny – and the tech sector has no margin of safety for political risk as the macro backdrop has started to shift in a more inflationary direction. Our colleague Juan Correa Ossa has shown that antitrust action to curb corporate power has tended to occur at times in US history where stock market earnings are elevated or rising rapidly relative to average wages, when inflation is running hot, and yet the economy has entered a bust phase where politicians are looking for a scapegoat to deflect public anger (Table 4). Table 4Stock Performance In Selected Judicial Events Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same While inflation is not an immediate problem (at least not yet), it was not a problem when the FTC and DOJ went after Microsoft starting in 1998. The distressed economy and tech bubble are good enough reason for investors to expect the government to increase antitrust pressure (Chart 17). If inflation recovers in the coming years around the time the Biden administration gains room to maneuver on this issue then it is doubly bad for the tech sector. Chart 17Anti-Trust Usually Follows Economic Bust Anti-Trust Usually Follows Economic Bust Anti-Trust Usually Follows Economic Bust In Microsoft’s case, the stock fell when the government first brought charges but rallied throughout the twists and turns of the courtroom – especially after 2002 when the case was settled, and ever since (Chart 18). Fortunately for the company the DOJ backed away from breakup and instead ordered it to open up its application programming to others. But even firms that are broken up usually create buying opportunities. Note that Microsoft cleared its image and has not become the subject of government or popular scrutiny again today. Today’s regulators are likely to place a greater burden of proof on tech companies attempting mergers and acquisitions. The alternative for startups is to hold an initial public offering – and IPOs have exploded amid the current context of low rates, easy money, investor exuberance, a chilling effect on M&A, and a lingering pandemic. The markets are frothy, buyer beware (Chart 19). Chart 18Microsoft's Anti-Trust Warning Microsoft's Anti-Trust Warning Microsoft's Anti-Trust Warning Chart 19Regulators Will Crack Down On M&A Regulators Will Crack Down On M&A Regulators Will Crack Down On M&A Strategically we remain favorable toward value stocks over growth stocks given the changing macro and policy backdrop outlined above (Chart 20). However, in the very near term we would not encourage investors to take on any additional risk. The latest bout of volatility is not necessarily over, political and geopolitical risks are now underrated after a period in which they subsided from peak levels, and exuberant markets are subject to very sharp corrections.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 20Take A Pause Amid Value Vs Growth Setback Take A Pause Amid Value Vs Growth Setback Take A Pause Amid Value Vs Growth Setback   Appendix Table A1Political Risk Matrix Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Table A2Biden’s Cabinet Position Appointments Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same   Footnotes 1     Congressional Budget Office, “Overview of the Economic Outlook: 2021-2031,” February 2021, cbo.gov. 2     Committee for a Responsible Federal Budget, “The Cost of the Trump and Biden Campaign Plans” October 7, 2020, and “The Cost of the Trump and Biden COVID Response Plans,” October 29, 2020, October 7, 2020, crfb.org. 3    The huge gap between the two parties can be illustrated by the recent case of Parler, the microblog that sought to rival Twitter by maintaining laissez faire content moderation standards. When Parler came under fire for attracting conservatives in the wake of the Twitter ban against Trump, Apple and Amazon teamed up to block it from their app purchasing and cloud services, thus effectively banning the app for 99% of users. There is no doubt that any private platform can regulate content according to its own standards on its own sites. In the words of Section 230, this extends not only to “obscene” or “excessively violent” material but to anything “otherwise objectionable.” But once tech companies prevent the emergence of competitors and alternatives, and cooperate in doing so, they enter much more dangerous legal territory. And yet the response from the House Democrats on the oversight committee was to ask the FBI to investigate Parler for hosting far-right extremists. Conservatives are therefore up in arms. The courts have not yet weighed in but the case represents a larger risk to the tech firms than the usual challenges under Section 230. 4    Representative Ken Buck, “The Third Way,” House Judiciary Committee, Subcommittee on Antitrust, Commercial, and Administrative Law 5    See Will Duffield, “Circumventing Section 230: Product Liability Lawsuits Threaten Internet Speech,” Cato Institute, January 26, 2021, cato.org. 6    See Ryan Grim and David Dayen, “Merrick Garland Wants Former Facebook Lawyer To Top Antitrust Division,” The Intercept, January 28, 2021, theintercept.com. 

Highlights The dollar bounce has further to run. The DXY index could touch 94 before working off oversold conditions. In this environment, yen long positions also provide an attractive hedge. Meanwhile, Japan has stepped back into deflation, with the resurgence in Covid-19 cases constraining activity and consumption spending. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. Remain strategically short USD/JPY. Tactical investors can also short EUR/JPY as a trade. Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. We were stopped out of our long silver/short gold position last week. Reinstate. Feature The powerful bounce in global markets from the March lows is morphing into a speculative frenzy. The highlight this week centered on a few stocks, such as GameStop, Blackberry, and AMC Entertainment holdings, that have entered a manic phase. While liquidity conditions remain extremely favorable for risk assets, only a small shift in market sentiment may be required to trigger a reversal. The big risk from a technical perspective is that this reversal might be deeper and longer than most expect, given extremely overbought conditions. The dollar has tended to strengthen as market volatility rises. 2020 saw the rapid accumulation of dollar shorts, as low interest rates squeezed investors into more speculative assets, such as cryptocurrencies (Chart I-1). With these assets now having  jumped high into the stratosphere, and dollar-short positioning at a bearish nadir, the nascent bounce in the USD could morph into something bigger. In our report a fortnight ago,1 we argued for a 2%-4% rise, putting 94 on the DXY index within striking distance. Chart I-1Some Signs Of Speculative Froth Some Signs Of Speculative Froth Some Signs Of Speculative Froth Chart I-2The Yen Benefits From A Rise In Volatility The Yen Benefits From A Rise In Volatility The Yen Benefits From A Rise In Volatility The yen also generally benefits from rising volatility (Chart I-2). Should a market correction develop, it will provide the necessary catalyst for established long yen positions. Meanwhile, as we argue below, the backdrop in Japan is becoming more deflationary, which is also yen bullish. We are already short USD/JPY in our portfolio and recommend going short EUR/JPY for a trade. The Yen And Global Markets The AUD/JPY rate is extremely sensitive to equity market conditions (Chart I-3). Therefore, one of the ways to play a potential reversal in equity markets and a rise in volatility is to short the AUD/JPY cross. While we certainly recommend this trade tactically, we prefer to express this view via a short EUR/JPY position. There are three main reasons for this.  First, despite a significant rally in AUD/JPY, speculators are still very short the cross, as we showed two weeks ago. This is because short USD positions have been expressed in a concentrated number of currencies, including the euro. In a nutshell, speculators are very long EUR/USD and just neutral EUR/JPY (Chart I-4). This favors EUR short positions from a contrarian perspective, compared to AUD. Chart I-3The Yen And Equity Markets The Yen And Equity Markets The Yen And Equity Markets Chart I-4Go Short EUR/JPY For A Trade Go Short EUR/JPY For A Trade Go Short EUR/JPY For A Trade Second, Australia is doing much better in terms of containing the spread of Covid-19, compared to Europe as we argued last week.2 Australian export volumes and prices continue to recover smartly, and the basic balance remains in a healthy surplus. Meanwhile, there is a rising risk that the Covid-19 crisis will hit Europe particularly hard in Q1 this year. Interest rate markets are already beginning to discount this view. Real interest rates in the euro area are collapsing relative to Japan (Chart I-5). This will limit any fixed-income flows into the euro area from Japanese investors. At the margin, this is negative EUR/JPY. Third, given the most recent stimulus out of Europe, the European Central Bank’s (ECB) balance sheet is expanding faster than that of the Bank of Japan (BoJ). This has historically been negative for the EUR/JPY (Chart I-6). Chart I-5EUR/JPY And Real Interest Rates EUR/JPY And Real Interest Rates EUR/JPY And Real Interest Rates Chart I-6EUR/JPY And Relative Balance Sheets EUR/JPY And Relative Balance Sheets EUR/JPY And Relative Balance Sheets In a nutshell, equity markets are due for a healthy reset. In a similar fashion, a washing out of stale euro long positions will ensure the bull market for 2021 unfolds with higher conviction. Tactical investors can also short EUR/JPY as a trade. Outright short EUR/USD positions also make sense in the near term.  The Yen And Japanese Growth Japan has re-entered a debt-deflation spiral, and it is unclear how it will exit this predicament, other than via a rebound in external demand. While it remains our base case that external demand will recover, the yen will be held hostage in the interim to short-term safe-haven inflows, as real rates remain well bid. Like most other economies, Japan is seeing the worst private-sector contraction in decades. For an economy that has held interest rates near zero since the better part of the 90s, this is not good news. Whenever the structural growth rate of the Japanese economy has fallen below interest rates, the trade-weighted yen has staged a powerful rally (Chart I-7). A strong yen, on the back of deficient domestic demand, then leads to a self-fulfilling deflationary spiral. Chart I-7The Story Of Japan In One Chart The Story Of Japan In One Chart The Story Of Japan In One Chart The latest Bank of Japan (BoJ) meeting was a clear indication that the central bank was out of policy bullets (the central bank left policy largely unchanged). The BoJ began to acknowledge this problem with the end of the Heisei era3 two years ago. A policy review is due in March of this year, but with aggressive stimulus in place since governor Haruhiko Kuroda took helm almost a decade ago, it is difficult to see how any changes could steer Japan out of deflation and towards a 2% inflation target anytime soon.  For example, with the BoJ owning 47% of outstanding JGBs, about 80% of ETFs and almost 5% of JREITs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. As a result, the impulse of the BoJ’s balance sheet could soon begin to fade, especially relative to that of other central banks (Chart I-8). Chart I-8The BoJ's Balance Sheet Could Peak Soon The BoJ's Balance Sheet Could Peak Soon The BoJ's Balance Sheet Could Peak Soon 2% Inflation = Mission Impossible? Most developed economies have not been able to meet their inflation targets over the last decade. While this might change going forward with unprecedented monetary and fiscal stimulus, it will not happen anytime soon. For example, the US is a much more closed economy than Japan and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream in the near future. Strictly looking at the data, the situation is even worse, with Japan having categorically stepped back into deflation (Chart I-9). The three key variables the authorities pay attention to for inflation – Core CPI, the GDP deflator, and the output gap – are all negative or rolling over. In fact, since the financial crisis, prices in Japan have only been able to really rise after a tax hike. Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and aging) population, leading to deficient demand (Chart I-10). Chart I-9Japan Is Back In Deflation Japan Is Back In Deflation Japan Is Back In Deflation Chart I-10Japan Prices And Demographics Japan Prices And Demographics Japan Prices And Demographics This view is corroborated in the inflation swap market. 5, 10, and 20-year inflation swaps in Japan are all depressed (Chart I-11). More importantly, with almost 50% of the Japanese consumption basket in tradeable goods, domestic inflation is as much driven by the influence of the BoJ or demographics, as it is by globalization. Chart I-11Is 2 Percent Inflation Mission Impossible? Is 2% Inflation Mission Impossible? Is 2% Inflation Mission Impossible? Fiscal Policy To The Rescue? Chart I-12Falling Consumer Confidence In Japan Falling Consumer Confidence In Japan Falling Consumer Confidence In Japan Most governments have carte blanche on fiscal stimulus. While it is certainly the case that the Japanese government could boost spending via transfer payments, much of this income is more likely to be saved than spent by the private sector. In other words, the savings ratio for workers continues to surge. If consumers were not willing to spend prior to COVID-19,4 they are unlikely to do so under much more uncertain future conditions (Chart I-12). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity, or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. The first is a potential postponement of the Olympics once again for 2021. This will continue to be a drag on Japanese construction activity. Second, the Covid-19 pandemic has severely curtailed tourism in Japan, especially as Niseko and Hakuba, important ski destinations for foreigners, lose inbound momentum. Tourism makes up a non-negligible component of Japanese income. Finally, the labor (and income) dividend from immigration has practically vanished. The Yen Beyond The Near Term Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. Real interest rates are already higher in Japan, and the above factors could meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-13). Chart I-13The Yen And Relative Interest Rates The Yen And Relative Interest Rates The Yen And Relative Interest Rates Chart I-14DXY And USD/JPY Usually Move Together DXY And USD/JPY Usually Move Together DXY And USD/JPY Usually Move Together A continued rise in global equity markets is a key risk to our scenario. This will especially favor short dollar positions. However, as a low-beta currency, our contention is that the yen will surely weaken at its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-14). While short EUR/JPY positions will suffer, short USD/JPY bets should still fare well. As such, we remain strategically short USD/JPY. It is rare to find such a “heads I win, tails I do not lose too much” proposition. Housekeeping We were stopped out of our long silver/short gold position for a modest profit of 6%. We have profitably traded silver for almost two years now, and could see a speculative breakout in the metal over the next few months. We recommend reinstating this trade today with the ratio at 71, while maintaining our target at 65 and setting the stop loss at 72.5. We were also stopped out of our long petrocurrency basket versus the euro. With heightened volatility in oil prices, we will be looking to re-establish this trade from lower levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange and Global Fixed Income Strategy report, "Australia: Regime Change For Bond Yields And Currency," dated January 20, 2021. 3 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito, from January 8, 1989 until his abdication on April 30, 2019. 4 Ricardian equivalence suggests in simple terms that public-sector dissaving will encourage private-sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart I-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been resilient: US manufacturing activity continues to outperform its peers, with a solid 59.1 print on the Markit PMI for January. The S&P CoreLogic house price index grew by 9.5% year-on-year in November. Consumer confidence remains resilient, with the expectations component surging for the month of January. 4Q GDP came in at an annualized 4% quarter-on-quarter, in line with expectations. The DXY index was flat this week. The latest FOMC meeting reinforced the view that there will be no rush to tighten US monetary policy. Two preconditions for tightening is inflation well above 2% and tight labor market conditions. This suggests the path for least resistance for the US dollar is down, albeit with some near-term consolidation. Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart I-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart I-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area are softening: Manufacturing PMIs are rolling over, with the aggregate index down to 54.7 in January from 55.2. The German IFO Business climate index also softened from 92.1 to 90.1 in January. GfK consumer confidence slipped from -7.3 to -15.6 in February. The euro fell by 0.3% against the US dollar this week. As the broad dollar continues to work off oversold conditions, the euro remains a potent valve to allow for this reset. We are shorting EUR/JPY this week to profit from any setback in risk assets.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart I-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart I-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been disappointing: Departmental store sales fell by 13.7% year-on-year in December. Retail sales are softening overall in Japan. Tokyo CPI will be released overnight and is expected to stay weak. The Japanese yen fell by 0.7% against the US dollar this week. Our highest conviction call over the next one to three months is to be long the yen both versus the dollar and versus the euro. As we discuss in the front section of this report, short USD/JPY is an attractive “heads I win, tails I do not lose too much” bet. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart I-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart I-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been softening: The Markit manufacturing PMI fell from 57.5 to 52.9 in January. 88K jobs were lost in the three months ending November. This pushed up the ILO unemployment rate to 5%. Average weekly earnings rose by 3.6% year-on-year in November. The British pound was flat against the US dollar this week. Post-Brexit relations and Covid-19 vaccinations continue to dominate the news flow in Britain. The latter is progressing, but a difficult adjustment remains for Britain’s exporters. This will add volatility to the pound. We remain short EUR/GBP on valuation grounds.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart I-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart I-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been improving: CPI went up a notch in the fourth quarter, to 0.9% from 0.7%. The weighted median number was more encouraging at 1.4% NAB Business conditions improved from 9 to 14 in December. However, the expectations component deteriorated from 12 to 4. 4Q export prices rose by 5.5% quarter-on-quarter. The Australian dollar fell by 0.9% against the US dollar this week. The Aussie has been consolidating gains for most of January. The dominant feature driving the Aussie in the near term will continue to be terms of trade. We expect the AUD to resume its uptrend after a brief consolidation phase. We shied from implementing a short AUD/JPY trade today, preferring to express this view via short EUR/JPY. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart I-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart I-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week:  The trade surplus in 2020 was NZ$2.9bn, compared to a deficit of NZ$4.5bn in 2019.  The New Zealand dollar fell by 0.4% against the US dollar this week. Agricultural prices are consolidating after a rebounding from the lows of last year. Poor weather continues to be a worry on the supply side, but this is already reflected in very long Ag positioning. More should continue to deflate air off the high-flying kiwi. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart I-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart I-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada continues to disappoint: Building permits fell by 4.1% month-on-month in December. The Canadian dollar plunged by 1.3% against the US dollar this week. Oil prices are consolidating this year’s gains, which has weighed on the loonie. There is also the issue of the cancelled keystone XL pipeline, which is adding a risk premium for Canadian crude. We are short CAD/NOK as a trade, to capitalize on the latter headwind. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart I-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart I-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: The Swiss franc fell by 0.3% against the US dollar this week. The Swiss national bank (SNB) has two headaches to contend with in the coming weeks: a potential correction in the euro, which encourages safe-haven flows into the franc, and the lagged effects on a strong currency on domestic prices. This will force the hand of the SNB to continue being foreign exchange reserves at an aggressive pace. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart I-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart I-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: The unemployment rate came down in November to 5% from 5.2%. The Norwegian krone fell by 2% this week on oil-related losses. Despite this, good management of the COVID-19 situation remains a positive catalyst relative to US or European peers. We expect the krone to keep outperforming for the rest of the year. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart I-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart I-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden has been mixed: The unemployment rate ticked up in December from 8.3% to 8.7%. Retail sales fell by 0.6% year-on-year in December, after rising by 5.7% the previous month. The trade balance improved from SEK1.4bn to SEK2.7bn in December. The Swedish krona fell by 0.8% against the US dollar this week. As a high beta currency, the Swedish krona typically bears the brunt of a US dollar rally. However, this time around, valuations provide a sufficient margin of safety for investors that are long. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. That was followed by a lost decade for EM. The US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Due to recurring stimulus, the US will experience asset bubbles and inflation in the real economy. The Fed will fall behind the inflation curve. The resulting downward pressure on the US dollar in the coming years favors EM stocks and fixed-income markets over their US counterparts. Feature Policymakers worldwide and in the US in particular “are riding a tiger”. Congress is authorizing unlimited spending and the government is on a borrowing and spending spree. So far there are no constraints on the ballooning budget deficit. Government bond yields are well behaved. In turn, the Fed is printing limitless money to finance the Treasury and there have been no market or economic constrictions. Share prices are at a record high and credit spreads are very tight. The US dollar is depreciating but it is a benign adjustment for the US because the greenback had been too strong for too long. Chart 1EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover In brief, the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. At the BCA annual conference in New York in 2016, one of the invited speakers – a hedge fund manager – recounted that in 2010, in a private conversation with an investor, Brazilian President Lula da Silva likened ruling Brazil to driving a sports car at high speed in the city with no police around. These were prescient words to describe the situation in Brazil’s economy and financial markets in 2009-10. In 2009-10, Brazil – like many other developing countries – benefited from both the impact of China’s enormous stimulus on commodities prices as well as from foreign capital inflows in part triggered by the Fed’s QE program. In addition, its own government provided sizeable monetary and fiscal stimulus. This stimulus trifecta – emanating from China, the US and local authorities – produced a one-off economic boom and a cyclical bull market in Brazil and other EM countries. Yet, the exuberance was followed by a stagflationary period in Brazil, and later a depression and associated rolling bear markets. Brazil was a poster child for that EM era. The experience of other EM economies was similar and the performance of their financial markets was equally underwhelming. These economies, their leaders, and financial markets wholly enjoyed the stimulus of that period. What followed, however, was a drawn-out hangover that lasted many years: EM ex-China, Korea and Taiwan share prices have been flat for the past 10 years and their currencies were depreciating till last spring (Chart 1). China, the epicenter of epic stimulus in 2009-10, had a similar experience. Its investable ex-TMT stocks, i.e., excluding Alibaba, Tencent and Meituan, are presently at the same level as they were in 2010 (Chart 2). The underlying cause has been a collapse in listed companies’ return on assets (Chart 2, bottom panel). It is essential to emphasize that such poor Chinese equity market performance occurred despite recurring fiscal and credit stimulus from Chinese authorities since 2009 (Chart 2, top panel). As we discussed in detail in a previous report, soft-budget constraints – unlimited stimulus and liquidity overflow – led to complacency, inefficiencies and falling return on capital in EM/China. Chart 3 demonstrates that EM EPS (including China, Korea and Taiwan and their TMT companies) has been flat for 10 years and non-financial companies’ return on assets plunged during the past decade. Chart 2China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability Chart 3EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade   Can The US Dismount The Tiger? The US is currently experiencing no budget constraints. US broad money (M2) growth is at a record high both in nominal and real terms (Chart 4). In turn, the fiscal thrust was 11.4% of GDP last year and will remain substantial this year as most of Biden’s stimulus plan is likely to gain approval from Congress.  Chart 4Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US Chart 5China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus Such an explosive boom in US money supply and fiscal largess will continue. Even after the pandemic is under control, it will be hard for policymakers to withdraw stimulus. China is a case in point. In the past 10 years, any time Beijing attempted to reduce the stimulus, China’s economic growth downshifted considerably and financial markets sold off (Chart 5, top panel). This forced Chinese policymakers to continuously enact new rounds of stimulus measures. As a result, they have not been able to achieve their goal of stabilizing the credit-to-GDP ratio (Chart 5, bottom panel). Similar dynamics will likely transpire in the US. Having been inflated enormously, US equity and corporate credit markets will be exceptionally sensitive to any policy shifts. US financial markets will riot at any attempt to withdraw monetary or fiscal stimulus. Given how sensitive US policymakers are to selloffs in financial markets, authorities will be extremely reluctant to exit these stimulative policies. Overall, the US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Bottom Line: Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount. Inflation, Asset Bubbles Or Capital Misallocation? In any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation. Charts 6 and 7 illustrate that rampant money/credit growth in Japan and Korea in the second half of the 1980s produced property and equity market bubbles. Chart 6Japan: Money And Asset Prices Japan: Money And Asset Prices Japan: Money And Asset Prices Chart 7Korea: Money And Asset Prices Korea: Money And Asset Prices Korea: Money And Asset Prices   Chart 8Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation In China’s case, the 2009-10 stimulus resulted in a property bubble as well as capital misallocation. Over the years, we have discussed these outcomes in China in detail and will not elaborate on them in this report. The pertinent question is why inflation has remained depressed in China. In fact, bouts of deflation occurred in various industries in China in the past 10 years. One usually associates a money/credit boom with demand exceeding supply resulting in higher inflation. That is correct if money/credit origination finances consumption with little capital expenditures taking place. However, the credit outburst in China enabled a capital spending boom. This led to a greater supply of goods and services, which in many cases exceeded underlying demand. The upshot has been deflation in various goods prices (Chart 8). History does not repeat but it rhymes. Open-ended stimulus in the US will eventually lead to years of economic and financial malaise. The nature of the challenges that the US will face matters not only to US financial markets but also to EM. Odds are that the US will experience asset bubbles and inflation in the real economy. We will not debate whether the US equity market is already in a bubble or not. Suffice it to say that in our opinion, parts of the market are already in a bubble. The main observation we will make in that regard is as follows: the sole way to justify the current broad US equity valuations is to assume that US Treasurys yields will not rise from the current levels. If US bond yields do not rise much, equity prices could hover at a high altitude. However, any mean reversion in US bond yields will deflate American share prices considerably. In turn, the outlook for US bond yields is contingent on the Fed’s willingness to continue with QE. We do not doubt the Fed will continue buying government securities until it faces a significant inflationary threat. Hence, the primary threat to US and global equity prices is inflation. Fertile Grounds For Inflation In The US Odds of inflation rising meaningfully above 2% in the US economy in the next 12-24 months have increased substantially:1 1. A combination of surging money supply and a potential revival in the velocity of money herald higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 4.  In the Special Report from October 22 we discussed in depth why US money growth is currently substantially stronger than the post-GFC period. With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed, the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 9). Chart 9The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum 2. Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will shrink (Chart 10).  Businesses will attempt to raise prices to restore their profit margins. Provided income and spending will be strong, companies could succeed in raising their prices. In the US, a modest wage-inflation spiral is probable in the coming years. Chart 10The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins Chart 11US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has produced shortages of manufacturing goods. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia and China are rising (Chart 11). In the service sector, lockdowns will permanently curtail capacity in some sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services, leading to shortages in certain segments. 4. De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. 5. Higher industry concentration and less competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed – it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulation, large companies have acquired smaller competitors. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases when the macro backdrop permits. In sum, US inflation will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main and overarching risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite cost pressures. Conclusions And Investment Strategy As America’s economy normalizes in the second half of this year, US inflationary pressures will begin rising. However, the Fed will fall behind the inflation curve – it will be late to acknowledge the potency of the inflationary pressures and act on it. It is typical for policymakers to downplay a budding new economic or financial tendency when they have long been pre-occupied with the opposite. Policymakers often fight past wars and are slow to calibrate their policy when the setting changes. The Fed falling behind the inflation curve is bearish for the US dollar in the medium and long-term. Share prices will be caught between rising inflationary pressures and the Fed’s continuous dovishness. This could create large swings in share prices: the market will sell off in response to evidence of rising inflation but will rebound after being calmed by the Fed. Eventually, fundamentals will prevail and the next US equity bear market will be due to higher inflation and rising bond yields. Over the coming several years, US share prices and bond yields will be negatively correlated as they were in the second half of the 1960s (Chart 12). Chart 12The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated Chart 13Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? This is not imminent, but it is not several years away either. Inflation could become the market’s focus later this year. Such a backdrop of heightening inflation risks and the Fed falling behind the curve will favor gold over equities – this ratio might be making a major bottom (Chart 13). In this context, we reiterate our trade of being long gold/short EM stocks. For now, global risk assets are extremely overbought and many of them are expensive. In short, they are overdue for a correction. During this setback, EM equities and credit markets will suffer and in the near term could even underperform their respective global benchmarks. In anticipation of such a setback, we have not upgraded EM to overweight. We continue to recommend maintaining a neutral allocation to EM in global equity and credit portfolios. Consistently, the US dollar will rebound because it is very oversold. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. High-risk currencies will underperform low-beta currencies. The EM/China backdrop remains disinflationary. Therefore, fixed-income investors should continue receiving 10-year swap rates in the following EM countries: Mexico, Colombia, Russia, China, Korea, India, and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1  This is the view of BCA’s Emerging Markets team and is different from BCA’s house view. The latter is more benign on the US inflation outlook in the coming years.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Pandemic uncertainty is keeping the USD well bid by raising global economic policy uncertainty. When this breaks – i.e., as higher vaccination rates push contagion rates down – the USD will resume its bear market. Renewable-energy output surpassed fossil-fuel generation in Europe for the first time in 2020. With the Biden administration re-committing to renewables, and China and Europe continuing their build-outs, copper demand will rise to meet grid-expansion needs. Copper mine output fell 0.5% in Jan-Oct 2020. Treatment and refining charges – already at 10-year lows – will remain depressed as supplies tighten. Major exchanges’ refined copper inventories were down 17% y/y in December, suggesting weak mine output continued into end-2020. Stocks will continue to fall this year, backwardating the COMEX's copper forward curve (Chart of the Week). Based on the World Bank’s forecast for real global GDP growth of 4% this year, and our expectation for a weaker USD, COMEX copper prices will likely breach $4.00/lb by 2H21. COVID-19 uncertainty drives metals: If infection and hospitalization rates outpace vaccinations, additional lockdowns in the US and Europe will stymie the recovery. Success in expanding vaccinations will push economic activity higher. We expect the latter outcome. Feature Pandemic uncertainty is driving global economic policy uncertainty, which is keeping a safe-haven bid under the USD (Chart 2). Chart of the WeekPhysical Copper Deficit Signals Continued Inventory Draws Physical Copper Deficit Signals Continued Inventory Draws Physical Copper Deficit Signals Continued Inventory Draws This continues to stymie the recovery in industrial commodity prices, particularly oil and base metals.1 The uncertainty caused by the COVID-19 pandemic feeds directly into global economic policy uncertainty, which drives USD safe-haven demand. Chart 2USD Remains In The Thrall Of Pandemic Uncertainty USD Remains In The Thrall Of Pandemic Uncertainty USD Remains In The Thrall Of Pandemic Uncertainty Pandemic uncertainty will not abate until vaccination distribution is sufficient to put infection, hospitalization and death rates on a clear downward trajectory, and remove the threat of widespread lockdowns, which once again are required to deal with rampant contagion rates and the possible spread of vaccine-resistant COVID-19 mutations locally and globally. As markets see empirical evidence of falling COVID-19-related infection, hospitalization and mortality, safe-haven demand for USD will weaken. Massive fiscal and monetary support will continue to support GDP globally, until organic growth takes off after sufficient populations are vaccinated, per the World Bank’s assumptions (Chart 3).2 Fiscal stimulus in the US exceeds 25% of GDP, and will continue to expand as the Biden administration rolls out additional spending measures. With the Fed remaining willing and able to accommodate this massive fiscal profligacy in the US, the USD will face increasing pressure on the downside as normalcy returns. Chart 3Massive Fiscal Support Globally Will Be Replaced By Organic Growth Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals A weaker USD and stronger economic growth would boost copper prices this year and the next. A 5% decline in the broad trade-weighted USD this year would push spot COMEX copper prices above $4.30/lb, all else equal, while a 4% boost in world GDP – in line with the World Bank’s forecast for real growth this year – would lift prices to just under $4.05/lb, based on our modeling (Chart 4).3 Chart 4Lower USD, Stronger GDP Bullish For Copper Prices Lower USD, Stronger GDP Bullish For Copper Prices Lower USD, Stronger GDP Bullish For Copper Prices Renewable Generation Will Boost Copper Demand In addition to these stronger fundamentals, base metals demand – particularly for copper – will continue to benefit from the build-out of renewable-energy electricity generation globally, particularly in Europe and China. The return of the US to the Paris Agreement to combat climate change, and a renewed effort by the Biden administration to fund expanded renewable-energy resources will add to the increase in base-metals demand accompanying this global build-out (Chart 5).4 Europe is moving out ahead of the US in its deployment of renewable electricity generation, which, for the first time ever, surpassed fossil-fuel generation in 2020.5 S&P Global Market Intelligence this week reported renewable energy sources accounted for 38% of electricity generation in the EU vs 37% for fossil fuels. Renewables also surpassed fossil-fuel generation in the UK last year. Wind, solar and hydro all saw strong gains. Chart 5Copper Is Indispensible For A Low-Carbon Future Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals Copper Supply Continues To Tighten It is important to once again note that all of these, and other renewable technologies, will require higher base metals output, none moreso than copper, which spans all renewable technologies. With copper-mining capex still weak and ore qualities falling in the mines that are producing, the supply side remains challenged (Chart 6). Over the past two years, p.a. supply growth on the mining side has been close to flat. The International Copper Study Group (ICSG) this week reported copper mine output fell 0.5% in the first 10 months of 2020. Refined copper output was up 1.5% over the same interval. Treatment and refining charges – already at 10-year lows – will remain depressed as supplies tighten. We expect full-year mined and refined output to fall on either side of zero growth for 2020, and 2021 (Chart 7).6 Major exchanges’ refined copper inventories were down 17% y/y in December, according to the ICSG, suggesting weak mine output continued into end-2020. An apparent increase in refined copper consumption of 2% noted by the ICSG also contributed to lower inventories. The Group estimates global refined copper balances adjusted for changes in Chinese bonded stocks, which are believed to have increased 105k tons y/y in the Jan-Dec 2020 interval, posted a physical deficit of ~ 380k tons. Chart 6Weak Capex, Lower Copper Ore Quality Remain Chief Supply-Side Challenges Weak Capex, Lower Copper Ore Quality Remain Chief Supply-Side Challenges Weak Capex, Lower Copper Ore Quality Remain Chief Supply-Side Challenges Chart 7Mined, Refined Copper Supply Growth Remains Weak Mined, Refined Copper Supply Growth Remains Weak Mined, Refined Copper Supply Growth Remains Weak We expect inventories will continue to fall this year – as seen in the Chart of the Week – as demand strengthens and supply growth remains weak, which will backwardate the COMEX copper forward curve. Metal Ox Year Brings Short-Term Uncertainties The approach of the Chinese New Year beginning 12 February 2021 normally would herald massive travel and celebration, which, all else equal, would dampen economic growth until festivities ended. This year, however, reports of a re-emergence of COVID-19 infections is casting doubt on this year’s celebrations. In addition, winter industrial curtailments to reduce pollution also should reduce short-term demand for metals generally. These transitory factors should show up in lower levels of economic activity on the industrial side. For this reason, we expect seasonal weakness to show up in 1Q21 activity, to be followed in 2Q21 by higher growth y/y. Bottom Line: Copper fundamentals continue to paint a bullish price picture, particularly on the supply side. Although risks abound on both sides of the market, we expect the massive support being provided by fiscal and monetary policy globally to transition to organic growth in 2H21, in line with the World Bank’s expectations. The enormous fiscal stimulus being unleashed by the US – coupled with an ultra-accommodative Fed – will result in a weakening of the USD that will provide a tailwind to copper prices in 2H21 and next year. We remain long the PICK ETF, expecting copper miners and traders to benefit from this bullish backdrop, which we expect to persist for the next decade. The recommendation is up 6.4% since inception December 10, 2020. We also remain long December 2021 copper, which is up 19.6% since it was recommended on September 10, 2020.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish After falling 11% in 2020 due to COVID-19-induced demand destruction, US energy-related CO2 emissions will rebound this year and next, according to the Energy Information Administration (Chart 8).  The EIA forecasts US energy-related CO2 emissions this year and next will be 4.8 and 4.9 billion MT, which would amount to a 4.7% and 3.2% gains, respectively.  The EIA tracks emissions from coal, petroleum and natural gas usage in the US in its estimates.  Petroleum accounts for ~ 46% of total emissions in 2021 and 2022, while natgas contributes ~ 33% of all energy-related emissions in both years, on average.  Reflecting its market-share loss in the power-generation market, coal accounts for ~ 21% of total US energy-related CO2 emissions in 2021 and 2022. Base Metals: Bullish Globally, crude steel production was down 0.9% y/y at 1.864 billion MT, the World Steel Association reported this week.  China’s steel production was up 5.2% last year, to 1.053 billion MT, the country a market share of 56.5%, up from 2019’s level of 53.3%.  Output in all of Asia totalled 1.375 billion MT, up 1.5% y/y, with India’s production falling close to 11% to 99.6 billion MT.  China’s iron-ore imports set a record last year on the back of its strong steel-making performance, reaching 1.2 billion tonnes, a 9.5% increase y/y.  Higher infrastructure spending was the primary driver of increased steel demand last year.  Iron ore delivered to the Chinese port of Tianjin (62% Fe) closed just above $169/MT on Tuesday, up ~ 9% YTD. Precious Metals: Bullish Gold continues to trade ~ $1,850/oz, down more than $100/oz from its highs earlier this month on the back of persistent USD strength (Chart 9).  The pandemic uncertainty feeding into global economic policy uncertainty is the proximate cause of dollar strength.  COVID-19 vaccine rates are increasing, and governments remain committed to widespread distribution, which likely will be visible to markets during 1H21.  Once this occurs, we expect gold to rally along with other commodities, as the safe-have bid is priced out of the USD. Ags/Softs: Neutral US corn prices rallied on the back of stronger China purchases of the grain on Tuesday.  Farm Futures reported a 53.5mm-bushel order out of China on Tuesday was responsible for the gain earlier this week.  Farmers continue to expect Chinese buying to remain strong, given falling corn stocks in China. Chart 8 Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals Chart 9 Gold Trading Lower On The Back of A Strong Dollar Gold Trading Lower On The Back of A Strong Dollar   Footnotes 1     At the margin, this increases the cost of purchasing commodities and lowers the cost of producing them ex-US in local-currency terms, both of which depress prices. Pandemic uncertainty and global economic policy uncertainty (GEPU) are cointegrated; the USD and GEPU also are cointegrated. We discussed the effects of pandemic uncertainty on the USD and its impact on oil prices in last week’s balances and price forecast update entitled Brent Forecast: $63 This Year, $71 Next Year. This report is available at ces.bcaresearch.com. 2     Please see the Bank's Global Economic Prospects released 5 January 2021 entitled Subdued Global Economic Recovery. The IMF upgraded its global growth outlook to 5.5% this year and 4.2% next year, in its World Economic Outlook Update released this week. We continue to use the more conservative World Bank forecasts. The Israeli economy is providing something of a natural experiment vis-à-vis the rate of COVID-19 vaccination and economic growth. According to reuters.com, the country got an early start on vaccinations, and has one of the highest rates in the world. If maintained, this will result in GDP growth of 6.3% in 2021 and 5.8% next year. Without these early and intensive vaccination rates, 2021 growth likely would be 3.5%. 3    The models in Chart 4 use the broad trade-weighted USD and global copper stocks as common regressors, and estimate copper prices given the World Bank estimates for World, EM ex-China, China and DM real GDPs. In the discussion above, we use elasticities from the World GDP model to highlight the impact of changes in copper prices from the different variables. 4    Please see Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020. We discuss the implications of essentially rebuilding the global electric-generation grid to accommodate more renewable energy resources vis-à-vis base metals demand. Copper, in particular, spans all technologies that will be deployed to achieve a low-carbon generation pool globally, as Chart 5 illustrates. 5    Please see For 1st time, renewables surpass fossil fuels in EU power mix published by S&P Global Market Intelligence 25 January 2021. 6    Benchmark treatment and refining fees charged by smelters to refine raw ore fell to 5.9 cent/lb this year, down from 6.2 cent/lb last year, according to reuters.com. This 10-year low reflects an abundance of smelting capacity relative to concentrates on the supply side needing to be refined.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way