Economic Growth

Highlights Biden’s first 100 days are characterized by a liberal spend-and-tax agenda unseen since the 1960s. It is not a “bait and switch,” however. Voters do not care about deficits and debt. At least not for now. The apparent outcome of the populist surge in the US and UK in 2016 is blowout fiscal spending. Yet the US and UK also invented and distributed vaccines faster than others. US growth and equities have outperformed while the US dollar experienced a countertrend bounce. While growth will rotate to other regions, China’s stimulus is on the wane. Of Biden’s three initial geopolitical risks, two are showing signs of subsiding: Russia and Iran. US-China tensions persist, however, and Biden has been hawkish so far. Our new Australia Geopolitical Risk Indicator confirms our other indicators in signaling that China risk, writ large, remains elevated. Cyclically we are optimistic about the Aussie and Australian stocks. Mexico’s midterm elections are likely to curb the ruling party’s majority but only marginally. The macro and geopolitical backdrop is favorable for Mexico. Feature US President Joe Biden gave his first address to the US Congress on April 28. Biden’s first hundred days are significant for his extravagant spending proposals, which will rank alongside those of Lyndon B. Johnson’s Great Society, if not Franklin Delano Roosevelt’s New Deal, in their impact on US history, for better and worse. Chart 1Biden's First 100 Days - The Market's Appraisal The global financial market appraisal is that Biden’s proposals will turn out for the better. The market has responded to the US’s stimulus overshoot, successful vaccine rollout, and growth outperformance – notably in the pandemic-struck service sector – by bidding up US equities and the dollar (Chart 1). From a macro perspective we share the BCA House View in leaning against both of these trends, preferring international equities and commodity currencies. However, our geopolitical method has made it difficult for us to bet directly against the dollar and US equities. Geopolitics is about not only wars and trade but also the interaction of different countries’ domestic politics. America’s populist spending blowout is occurring alongside a sharp drop in China’s combined credit-and-fiscal impulse, which will eventually weigh on the global economy. This is true even though the rest of the world is beginning to catch up in vaccinations and economic normalization. As for traditional geopolitical risk – wars and alliances – Biden has not yet leaped over the three initial foreign policy hurdles that we have highlighted: China, Russia, and Iran. In this report we will update the view on all three, as there is tentative improvement on the Russian and Iranian fronts. In addition, we will introduce our newest geopolitical risk indicator – for Australia – and update our view on Mexico ahead of its June 6 midterm elections. Biden’s Fiscal Blowout From a macro point of view, Biden’s $1.9 trillion American Rescue Plan Act (ARPA) was much larger than what Republicans would have passed if President Trump had won a second term. His proposed $2.3 trillion American Jobs Plan (AJP) is also larger, though both candidates were likely to pass an infrastructure package. The difference lies in the parts of these packages that relate to social spending and other programs, beyond COVID relief and roads and bridges. The Republican proposal for COVID relief was $618 billion while the Republicans’ current proposal on infrastructure is $568 billion – marking a $3 trillion difference from Biden. In reality Republicans would have proposed larger spending if Trump had remained president – but not enough to close this gap. And Biden is also proposing a $1.8 trillion American Families Plan (AFP). Biden’s praise for handling the vaccinations must be qualified by the Trump administration’s successful preparations, which have been unfairly denigrated. Similarly, Biden’s blame for the migrant surge at the southern border must be qualified by the fact that the surge began last year.1 A comparison with the UK will put Biden’s administration into perspective. The only country comparable to the US in terms of the size of fiscal stimulus over 2019-21 so far – excluding Biden’s AJP and AFP, which are not yet law – is the United Kingdom. Thus the consequence of the flare-up of populism in the Anglo-Saxon world since 2016 is a budget deficit blowout as these countries strive to suppress domestic socio-political conflict by means of government largesse, particularly in industrial and social programs. However, populist dysfunction was also overrated. Both the US and UK retain their advantages in terms of innovation and dynamism, as revealed by the vaccine and its rollout (Chart 2). Chart 2Dysfunctional Anglo-Saxon Populism? No sharp leftward turn occurred in the UK, where Prime Minister Boris Johnson and his Conservatives had the benefit of a pre-COVID election in December 2019, which they won. By contrast, in the US, President Trump and the Republicans contended an election after the pandemic and recession had virtually doomed them to failure. There a sharp leftward turn is taking place. Going forward the US will reclaim the top rank in terms of fiscal stimulus, as Biden is likely to get his infrastructure plan (AJP) passed. Our updated US budget deficit projections appear in Chart 3. Our sister US Political Strategy gives the AJP an 80% chance of passing in some form and the AFP only a 50% chance of passing, depending on how quickly the AJP is passed. This means the blue dashed line is more likely to occur than the red dashed line. The difference is slight despite the mind-boggling headline numbers of the plans because the spending is spread out over eight-to-ten years and tax hikes over 15 years will partially offset the expenditures. Much will depend on whether Congress is willing to pay for the new spending. In Chart 3 we assume that Biden will get half of the proposed corporate tax hikes in the AJP scenario (and half of the individual tax hikes in the AFP scenario). If spending is watered down, and/or tax hikes surprise to the upside, both of which are possible, then the deficit scenarios will obviously tighten, assuming the economic recovery continues robustly as expected. But in the current political environment it is safest to plan for the most expansive budget deficit scenarios, as populism is the overriding force. Chart 3Biden’s Blowout Spending Biden’s campaign plan was even more visionary, so it is not true that Biden pulled a “bait and switch” on voters. Rather, the median voter is comfortable with greater deficits and a larger government role in American life. Bottom Line: The implication of Biden’s spending blowout is reflationary for the global economy, cyclically negative for the US dollar, and positive for global equities. But on a tactical time frame the rotation to other equities and currencies will also depend on China’s fiscal-and-credit deceleration and whether geopolitical risk continues to fall. Russia: Some Improvement But Coast Not Yet Clear US-Russia tensions appeared to fizzle over the past week but the coast is not yet clear. We remain short Russian currency and risk assets as well as European emerging market equities. Tensions fell after President Putin’s State of the Nation address on April 21 in which he warned the West against crossing Russia’s “red lines.” Biden’s sanctions on Russia were underwhelming – he did not insist on halting the final stages of the Nord Stream II pipeline to Germany. Russia declared it would withdraw its roughly 100,000 troops from the Ukrainian border by May 1. Russian dissident Alexei Navalny ended his hunger strike. Putin attended Biden’s Earth Day summit and the two are working on a bilateral summit in June. Chart 4Russia's Domestic Instability Will Continue De-escalation is not certain, however. First, some US officials have cast doubt on Russia’s withdrawal of troops and it is known that arms and equipment were left in place for a rapid mobilization and re-escalation if necessary. Second, Russian-backed Ukrainian separatists will be emboldened, which could increase fighting in Ukraine that could eventually provoke Russian intervention. Third, the US has until August or September to prevent Nord Stream from completion. Diplomacy between Russia and the US (and Russia and several eastern European states) has hit a low point on the withdrawal of ambassadors. Fourth, Russian domestic politics was always the chief reason to prepare for a worse geopolitical confrontation and it remains unsettled. Putin’s approval rating still lingers in the relatively low range of 65% and government approval at 49%. The economic recovery is weak and facing an increasingly negative fiscal thrust, along with Europe and China, Russia’s single-largest export destination (Chart 4). Putin’s handouts to households, in anticipation of the September Duma election, only amount to 0.2% of GDP. More measures will probably be announced but the lead-up to the election could still see an international adventure designed to distract the public from its socioeconomic woes. Russia’s geopolitical risk indicators ticked up as anticipated (Chart 5). They may subside if the military drawdown is confirmed and Biden and Putin lower the temperature. But we would not bet on it. Chart 5Russian Geopolitical Risk: Wait For 'All Clear' Signal Bottom Line: It is possible that Biden has passed his first foreign policy test with Russia but it is too soon to sound the “all clear.” We remain short Russian ruble and short EM Europe until de-escalation is confirmed. The Russian (and German) elections in September will mark a time for reassessing this view. Iran: Diplomacy On Track (Hence Jitters Will Rise) While Russia may or may not truly de-escalate tensions in Ukraine, the spring and summer are sure to see an increase in focus on US-Iran nuclear negotiations. Geopolitical risks will remain high prior to the conclusion of a deal and will materialize in kinetic attacks of various kinds. This thesis is confirmed by the alleged Israeli sabotage of Iran’s Natanz nuclear facility this month. The US Navy also fired warning shots at Iranian vessels staging provocations. Sporadic attacks in other parts of the region also continue to flare, most recently with an Iranian tanker getting hit by a drone at a Syrian oil terminal.2 The US and Iran are making progress in the Vienna talks toward rejoining the 2015 nuclear deal from which the US withdrew in 2018. Iran pledged to enrich uranium up to 60% but also said this move was reversible – like all its tentative violations of the Joint Comprehensive Plan of Action (JCPA) so far (Table 1). Iran also offered a prisoner swap with the US. Saudi Arabia appears resigned to a resumption of the JCPA that it cannot prevent, with crown prince Mohammed bin Salman offering diplomatic overtures to both the US and Iran. Table 1Iran’s Nuclear Program And Compliance With JCPA 2015 Still, the closer the US and Iran get to a deal the more its opponents will need to either take action or make preparations for the aftermath. The allegation that former US Secretary of State John Kerry’s shared Israeli military plans with Iranian Foreign Minister Javad Zarif is an example of the kind of political brouhaha that will occur as different elements try to support and oppose the normalization of US-Iran ties. More importantly Israel will underscore its red line against nuclear weaponization. Previously Iran was set to reach “breakout” capability of uranium enrichment – a point at which it has enough fissile material to produce a nuclear device – as early as May. Due to sabotage at the Natanz facility the breakout period may have been pushed back to July.3 This compounds the significance of this summer as a deadline for negotiating a reduction in tensions. While the US may be prepared to fudge on Iran’s breakout capabilities, Israel will not, which means a market-relevant showdown should occur this summer before Israel backs down for fear of alienating the United States. Tit-for-tat attacks in May and June could cause negative surprises for oil supply. Then there will be a mad dash by the negotiators to agree to deal before the de facto August deadline, when Iran inaugurates a new president and it becomes much harder to resolve outstanding issues. Chart 6Iran Deal Priced Into Oil Markets? Hence our argument that geopolitics adds upside risk to oil prices in the first half of the year but downside risk in the second half. The market’s expectations seem already to account for this, based on the forward curve for Brent crude oil. The marginal impact of a reconstituted Iran nuclear deal on oil prices is slightly negative over the long run since a deal is more likely to be concluded than not and will open up Iran’s economy and oil exports to the world. However, our Commodity & Energy Strategy expects the Brent price to exceed expectations in the coming years, judging by supply and demand balances and global macro fundamentals (Chart 6). If an Iran deal becomes a fait accompli in July and August the Saudis could abandon their commitment to OPEC 2.0’s production discipline. The Russians and Saudis are not eager to return to a market share war after what happened in March 2020 but we cannot rule it out in the face of Iranian production. Thus we expect oil to be volatile. Oil producers also face the threat of green energy and US shale production which gives them more than one reason to keep up production and prevent prices from getting too lofty. Throughout the post-2015 geopolitical saga between the US and Iran, major incidents have caused an increase in the oil-to-gold ratio. The risk of oil supply disruption affected the price more than the flight to gold due to geopolitical or war risk. The trend generally corresponds with that of the copper-to-gold ratio, though copper-to-gold rose higher when growth boomed and oil outperformed when US-Iran tensions spiked in 2019. Today the copper-to-gold ratio is vastly outperforming the oil-to-gold on the back of the global recovery (Chart 7). This makes sense from the point of view of the likelihood of a US-Iran deal this year. But tensions prior to a deal will push up oil-to-gold in the near term. Chart 7Biden Passes Iran Test? Likely But Not A Done Deal Bottom Line: The US-Iran diplomacy is on track. This means geopolitical risk will escalate in May and June before a short-term or interim deal is agreed in July or August. Geopolitical risk stemming from US-Iran relations will subside thereafter, unless the deadline is missed. The forward curve has largely priced in the oil price downside except for the risk that OPEC 2.0 becomes dysfunctional again. We expect upside price surprises in the near term. Biden, China, And Our Australia GeoRisk Indicator Ostensibly the US and Russia are avoiding a war over Ukraine and the US and Iran are negotiating a return to the 2015 nuclear deal. Only US-China relations utterly lack clarity, with military maneuvering in the Taiwan Strait and South China Sea and tensions simmering over the gamut of other disputes. Chart 8Biden Still Faces China Test The latest data on global military spending show not only that the US and China continue to build up their militaries but also that all of the regional allies – including Japan! – are bulking up defense spending (Chart 8). This is a substantial confirmation of the secular growth of geopolitical risk, specifically in reaction to China’s rise and US-China competition. The first round of US-China talks under Biden went awry but since then a basis has been laid for cooperation on climate change, with President Xi Jinping attending Biden’s virtual climate change summit (albeit with no bilateral summit between the two). If John Kerry is removed as climate czar over his Iranian controversy it will not have an impact other than to undermine American negotiators’ reliability. The deeper point is that climate is a narrow basis for US-China cooperation and it cannot remotely salvage the relationship if a broader strategic de-escalation is not agreed. Carbon emissions are more likely to become a cudgel with which the US and West pressure China to reform its economy faster. The Department of Defense is not slated to finish its comprehensive review of China policy until June but most US government departments are undertaking their own reviews and some of the conclusions will trickle out in May, whether through Washington’s actions or leaks to the press. Beijing could also take actions that upend the Biden administration’s assessment, such as with the Microsoft hack exposed earlier this year. The Biden administration will soon reveal more about how it intends to handle export controls and sanctions on China. For example, by May 19 the administration is slated to release a licensing process for companies concerned about US export controls on tech trade with China due to the Commerce Department’s interim rule on info tech supply chains. The Biden administration looks to be generally hawkish on China, a view that is now consensus. Any loosening of punitive measures would be a positive surprise for Chinese stocks and financial markets in general. There are other indications that China’s relationship with the West is not about to improve substantially – namely Australia. Australia has become a bellwether of China’s relations with the world. While the US’s defense commitments might be questionable with regard to some of China’s neighbors – namely Taiwan (Province of China) but also possibly South Korea and the Philippines – there can be little doubt that Australia, like Japan, is the US’s red line in the Pacific. Australian politics have been roiled over the past several years by the revelation of Chinese influence operations, state- or military-linked investments in Australia, and propaganda campaigns. A trade war erupted last year when Australia called for an investigation into the origins of COVID-19 and China’s handling of it. Most recently, Victoria state severed ties with China’s Belt and Road Initiative. Despite the rise in Sino-Australian tensions, the economic relationship remains intact. China’s stimulus overweighed the impact of its punitive trade measures against Australia, both by bidding up commodity prices and keeping the bulk of Australia’s exports flowing (Chart 9). As much as China might wish to decouple from Australia, it cannot do so as long as it needs to maintain minimum growth rates for the sake of social stability and these growth rates require resources that Australia provides. For example, global iron ore production excluding Australia only makes up 80% of China’s total iron ore imports, which necessitates an ongoing dependency here (Chart 10). Brazil cannot make up the difference. Chart 9China-Australia Trade Amid Tensions Chart 10China Cannot Replace Australia This resource dependency does not necessarily reduce geopolitical tension, however, because it increases China’s supply insecurity and vulnerability to the US alliance. The US under Biden explicitly aims to restore its alliances and confront autocratic regimes. This puts Australia at the front lines of an open-ended global conflict. Chart 11Introducing: Australia GeoRisk Indicator (Smoothed) Our newly devised Australia GeoRisk Indicator illustrates the point well, as it has continued surging since the trade war with China first broke out last year (Chart 11). This indicator is based on the Australian dollar and its deviation from underlying macro variables that should determine its course. These variables are described in Appendix 1. If the Aussie weakens relative to these variables, then an Australian-specific risk premium is apparent. We ascribe that premium to politics and geopolitics writ large. A close examination of the risk indicator’s performance shows that it tracks well with Australia’s recent political history (Chart 12). Previous peaks in risk occurred when President Trump rose to power and Australia, like Canada, found itself beset by negative pressures from both the US and China. In particular, Trump threatened tariffs and the Australian government banned China’s Huawei from its 5G network. Today the rise in geopolitical risk stems almost exclusively from China. There is potential for it to roll over if Biden negotiates a reduction in tensions but that is a risk to our view (an upside risk for Australian and global equities). Chart 12Australian GeoRisk Indicator (Unsmoothed) What does this indicator portend for tradable Australian assets? As one would expect, Australian geopolitical risk moves inversely to the country’s equities, currency, and relative equity performance (Chart 13). Australian equities have risen on the back of global growth and the commodity boom despite the rise in geopolitical risk. But any further spike in risk could jeopardize this uptrend. Chart 13Australia Geopolitical Risk And Tradable Assets An even clearer inverse relationship emerges with the AUD-JPY exchange rate, a standard measure of risk-on / risk-off sentiment in itself. If geopolitical risk rises any further it should cause a reversal in the currency pair. Finally, Australian equities have not outperformed other developed markets excluding the US, which may be due to this elevated risk premium. Bottom Line: China is the most important of Biden’s foreign policy hurdles and unlike Russia and Iran there is no sign of a reduction in tension yet. Our Australian GeoRisk Indicator supports the point that risk remains very elevated in the near term. Moreover China’s credit deceleration is also negative for Australia. Cyclically, however, assuming that China does not overtighten policy, we take a constructive view on the Aussie and Australian equities. Biden’s Border Troubles Distract From Bullish Mexico Story The biggest criticism of Biden’s first 100 days has been his reduction in a range of enforcement measures on the southern border which has encouraged an overflow of immigrants. Customs and Border Patrol have seen a spike in “encounters” from a low point of around 17,000 in 2020 to about 170,000 today. The trend started last year but accelerated sharply after the election and had surpassed the 2019 peak of 144,000. Vice President Kamala Harris has been put in charge of managing the border crisis, both with Mexico and Central American states. She does not have much experience with foreign policy so this is her opportunity to learn on the job. She will not be able to accomplish much given that the Biden administration is unwilling to use punitive measures or deterrence and will not have large fiscal resources available for subsidizing the nations to the south. With the US economy hyper-charged, especially relative to its southern neighbors, the pace of immigration is unlikely to slacken. From a macro point of view the relevance is that the US is not substantially curtailing immigration – quite the opposite – which means that labor force growth will not deviate from its trend. What about Mexico itself? It is not likely that Harris will be able to engage on a broader range of issues with Mexico beyond immigration. As usual Mexico is beset with corruption, lawlessness, and instability. To these can be added the difficulties of the pandemic and vaccine rollout. Tourism and remittances are yet to recover. Cooperation with US federal agents against the drug cartels is deteriorating. Cartels control an estimated 40% of Mexican territory.4 Nevertheless, despite Mexico’s perennial problems, we hold a positive view on Mexican currency and risk assets. The argument rests on five points: Strong macro fundamentals: With China’s fiscal-and-credit impulse slowing sharply, and US stimulus accelerating, Mexico stands to benefit. Mexico has also run orthodox monetary and fiscal policies. It has a demographic tailwind, low wages, and low public debt. The stars are beginning to align for the country’s economy, according to our Emerging Markets Strategy. US and Canadian stimulus: The US and Canada have the second- and third-largest fiscal stimulus of all the major countries over the 2019-21 period, at 9% and 8% of GDP respectively. Mexico, with the new USMCA free trade deal in hand, will benefit. US protectionism fizzled: Even Republican senators blocked President Trump’s attempted tariffs on Mexico. Trump’s aggression resulted in the USMCA, a revised NAFTA, which both US political parties endorsed. Mexico is inured to US protectionism, at least for the short and medium term. Diversification from China: Mexico suffered the greatest opportunity cost from China’s rise as an offshore manufacturer and entrance to the World Trade Organization. Now that the US and other western countries are diversifying away from China, amid geopolitical tensions, Mexico stands to benefit. The US cannot eliminate its trade deficit due to its internal savings/investment imbalance but it can redistribute that trade deficit to countries that cannot compete with it for global hegemony. AMLO faces constraints: A risk factor stemmed from politics where a sweeping left-wing victory in 2018 threatened to introduce anti-market policies. President Andrés Manuel López Obrador (known as AMLO) and his MORENA party gained a majority in both houses of the legislature. Their coalition has a two-thirds majority in the lower house (Chart 14). However, we pointed out that AMLO’s policies have not been radical and, more importantly, that the midterm election would likely constrain his power. Chart 14Mexico’s Midterm Election Looms These are all solid points but the last item faces a test in the upcoming midterm election. AMLO’s approval rating is strong, at 63%, putting him above all of his predecessors except one (Chart 15). AMLO’s approval has if anything benefited from the COVID-19 crisis despite Mexico’s inability to handle the medical challenge. He has promised to hold a referendum on his leadership in early 2022, more than halfway through his six-year term, and he is currently in good shape for that referendum. For now his popularity is helpful for his party, although he is not on the ballot in 2021 and MORENA’s support is well beneath his own. Chart 15AMLO’s Approval Fairly Strong MORENA’s support is holding at a 44% rate of popular support and its momentum has slightly improved since the pandemic began. However, MORENA’s lead over other parties is not nearly as strong as it was back in 2018 (Chart 16, top panel). The combined support of the two dominant center-right parties, the Institutional Revolutionary Party and the National Action Party, is almost equal to that of MORENA. And the two center-left parties, the Democratic Revolution Party and Citizen’s Movement, are part of the opposition coalition (Chart 16, bottom panel). The pandemic and economic crisis will motivate the opposition. Chart 16MORENA’s Support Holding Up Despite COVID Traditionally the president’s party loses seats in the midterm election (Table 2). Circumstances are different from the US, which also exhibits this trend, because Mexico has more political parties. A loss of seats from MORENA does not necessarily favor the establishment parties. Nevertheless opinion polling shows that about 45% of voters say they would rather see MORENA’s power “checked” compared to 41% who wish to see the party go on unopposed.5 Table 2Mexican President’s Party Tends To Lose Seats In Midterm Election While the ruling coalition may lose its super-majority, it is not a foregone conclusion that MORENA will lose its majority. Voters have decades of experience of the two dominant parties, both were discredited prior to 2018, and neither has recovered its reputation so quickly. The polling does not suggest that voters regret their decision to give the left wing a try. If anything recent polls slightly push against this idea. If MORENA surprises to the upside then AMLO’s capabilities would increase substantially in the second half of his term – he would have political capital and an improving economy. While the senate is not up for grabs in the midterm, MORENA has a narrow majority and controls a substantial 60% of seats when its allies are taken into account. In this scenario AMLO could pursue his attempts to increase the state’s role in key industries, like energy and power generation, at the expense of private investors. Even then the Supreme Court would continue to act as a check on the government. The 11-seat court is currently made up of five conservatives, two independents, and three liberal or left-leaning judges. A new member, Margarita Ríos Farjat, is close to the government, leaving the conservatives with a one-seat edge over the liberals and putting the two independents in the position of swing voters. Even if AMLO maintains control of the lower house, he will not be able to override the constitutional court, as he has threatened on occasion to do, without a super-majority in the senate. Bottom Line: AMLO will likely lose some ground in the lower house and thus suffer a check on his power. This will only confirm that Mexican political risk is not likely to derail positive underlying macro fundamentals. Continue to overweight Mexican equities relative to Brazilian.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix 1 The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our Australian GeoRisk Indicator (see Chart 11-12 above) uses the same simple methodology used in our other indicators, which avoid the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the AUD, and compare its movement against several fundamental factors – in this case global energy and base metal prices, global metals and mining stock prices, and the Chilean peso. Australia is a commodity-exporting country. It is the largest producer of iron ore and is among the largest producers of coal and natural gas. It is also a major trading partner for China. Due to the nature of its economy the Australian dollar moves with global metal and energy prices and the global metals and mining equity prices. Chile, another major commodity producer also moves with global metal prices, hence our inclusion of the peso in this indicator. The AUD has a high correlation with all of these assets, and if the changes in the value of the AUD lag or lead the changes in the value of these assets, the implication is that geopolitical risk unique to Australia is not priced by the market. We included the peso as Chile is not as affected as Australia by any conflict in the South China Sea or Northeast Asia, which means that a deviation of the AUD from CLP represents a unique East Asia Pacific risk. Our indicator captures the involvement of Australia in a few regional and international conflicts. The indicator climbed as Australia got involved in the East Timor emergency and declined as it exited. It continued declining even as Australia joined the US in the Afghanistan and Iraq wars, which showed that investors were unperturbed by faraway wars, while showing measurable concern in the smaller but closer Timorese conflict. Risks went up again as the nation erupted in labor protests as the Howard government made changes to the labor code. We see the market pricing higher risk again during the 2008 financial crisis, although it was modest and Australia escaped the crisis unscathed due to massive Chinese stimulus. Since then, investors have been climbing a wall of worry as they priced in Northeast Asia-related geopolitical risks. These started with the South Korean Cheonan sinking and continued with the Sino-Japanese clash over the Senkaku islands. They culminated with the Chinese ADIZ declaration in late 2013. In 2016, Australia was shocked again when Donald Trump was elected, and investor fears were evident when the details of Trump-Turnbull spat were made public. The risk indicator reached another peak during the trade wars between the US and the rest of the world. Investors were not worried about COVID-19 as Australia largely contained the pandemic, but the recent Australian-Chinese trade war pushed the risk indicator up, giving investors another wall of worry. If the Biden administration forces Australia into a democratic alliance in confrontation with autocratic China then this risk will persist for some time.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com We Read (And Liked) ... The Narrow Corridor: States, Societies, And The Fate Of Liberty This book is a sweeping review of the conditions of liberty essential to steering the world away from the Hobbesian war of all against all. In this unofficial sequel to the 2012 hit, Why Nations Fail: The Origins Of Power, Prosperity, And Poverty, Daron Acemoglu (Professor of Economics at the Massachusetts Institute of Technology) and James A. Robinson (Professor of Global Conflict Studies at the University of Chicago) further explore their thesis that the existence and effectiveness of democratic institutions account for a nation’s general success or failure. The Narrow Corridor6 examines how liberty works. It is not “natural,” not widespread, “is rare in history and is rare today.” Only in peculiar circumstances have states managed to produce free societies. States have to walk a thin line to achieve liberty, passing through what the authors describe as a “narrow corridor.” To encourage freedom, states must be strong enough to enforce laws and provide public services yet also restrained in their actions and checked by a well-organized civil society. For example, from classical history, the Athenian constitutional reforms of Cleisthenes “were helpful for strengthening the political power of Athenian citizens while also battling the cage of norms.” That cage of norms is the informal body of customs replaced by state institutions. Those norms in turn “constrained what the state could do and how far state building could go,” providing a set of checks. Though somewhat fluid in its definition, liberty, as Acemoglu and Robinson show, is expressed differently under various “leviathans,” or states. For starters, the “Shackled Leviathan” is a government dedicated to upholding the rule of law, protecting the weak against the strong, and creating the conditions for broad-based economic opportunity. Meanwhile, the “Paper Leviathan” is a bureaucratic machine favoring the privileged class, serving as both a political and economic brake on development and yielding “fear, violence, and dominance for most of its citizens.” Other examples include: The “American Leviathan” which fails to deal properly with inequality and racial oppression, two enemies of liberty; and a “Despotic Leviathan,” which commands the economy and coerces political conformity – an example from modern China. Although the book indulges in too much jargon, it is provocative and its argument is convincing. The authors say that in most places and at most times, the strong have dominated the weak and human freedom has been quashed by force or by customs and norms. Either states have been too weak to protect individuals from these threats or states have been too strong for people to protect themselves from despotism. Importantly, many states believe that once liberty is achieved, it will remain the status quo. But the authors argue that to uphold liberty, state institutions have to evolve continuously as the nature of conflicts and needs of society change. Thus society's ability to keep state and rulers accountable must intensify in tandem with the capabilities of the state. This struggle between state and society becomes self-reinforcing, inducing both to develop a richer array of capacities just to keep moving forward along the corridor. Yet this struggle also underscores the fragile nature of liberty. It is built on a precarious balance between state and society; between economic, political, and social elites and common citizens; between institutions and norms. If one side of the balance gets too strong, as has often happened in history, liberty begins to wane. The authors central thesis is that the long-run success of states depends on the balance of power between state and society. If states are too strong, you end up with a “Despotic Leviathan” that is good for short-term economic growth but brittle and unstable over the long term. If society is too strong, the “Leviathan” is absent, and societies suffer under a pre-modern war of all against all. The ideal place to be is in the narrow corridor, under a shackled Leviathan that will grow state capacity and individual liberty simultaneously, thus leading to long-term economic growth. In the asset allocation process, investors should always consider the liberty of a state and its people, if a state’s institutions grossly favor the elite or the outright population, whether these institutions are weak or overbearing on society, and whether they signify a balance between interests across the population. Whether you are investing over a short or long horizon, returns can be significantly impacted in the absence of liberty or the excesses of liberty. There should be a preference among investors toward countries that exhibit a balance of power between state and society, setting up a better long-term investment environment, than if a balance of power did not exist.   Guy Russell Research Analyst GuyR@bcaresearch.com GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Footnotes 1 "President Biden’s first 100 days as president fact-checked," BBC News, April 29, 2021, bbc.com. 2 "Oil tanker off Syrian coast hit in suspected drone attack," Al Jazeera, April 24, 2021, Aljazeera.com. 3 See Yaakov Lappin, "Natanz blast ‘likely took 5,000 centrifuges offline," Jewish News Syndicate, jns.org. 4 John Daniel Davidson, "Former US Ambassador To Mexico: Cartels Control Up To 40 Percent Of Mexican Territory," The Federalist, April 28, 2021, thefederalist.com. 5 See Alejandro Moreno, "Aprobación de AMLO se encuentra en 61% previo a campañas electorales," El Financiero, April 5, 2021, elfinanciero.com. 6 Penguin Press, New York, NY, 2019, 558 pages. Section III: Geopolitical Calendar

Highlights The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. Feature In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,1 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP2 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.3 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,1 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.4 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 2 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 3 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 4 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights Clients countered our opinion that China’s economy has reached its cyclical peak. However, we have already incorporated the supporting facts into our analysis so they will not alter our cyclical outlook for the economy. The favorable external backdrop is a potential downside risk to China’s domestic economy, because the country’s pain threshold for reform is often positively correlated with global growth. We agree that an acceleration in local governments’ special-purpose bond issuance could boost infrastructure investment in the next six months, but we are skeptical about the magnitude of such support. China’s onshore and offshore stock markets remain firmly in a risk-off mode. For now, we recommend investors stay on the sidelines until some of the early indicators turn more bullish. Feature We spent the past week hosting virtual meetings with BCA’s clients in Europe and Asia. We presented our view that China’s economic recovery has likely peaked and escalating risks of a policy overtightening warrant an underweight position on Chinese stocks for the next six months. Most clients shared our concern that policymakers may keep financial and industry regulations more restrictive than the market is currently pricing in, leading to more downside surprises to risk asset prices. Clients also brought up a few opposing views which challenged our analytical framework. In this and next week’s reports we will highlight some of the counterpoints we discussed in these meetings. Interestingly, most of our clients - even ones who are more sanguine about China’s economic outlook - prefer to wait on the sidelines before jumping back into China’s equity market. They foresee sustained volatility in the coming months as the market continues to struggle between digesting high valuations and adjusting expectations for future earnings growth. Has China’s Economic Recovery Reached An Apex? The primary discussion centered around whether the strength in China’s economy has reached a cyclical peak. Q1 GDP points to slower sequential economic momentum from Q4 last year (Chart 1). Some of the high-frequency economic data also indicate that economic activity peaked in Q4 last year (Chart 2).  Chart 1Q1 Sequential Growth Was The Slowest In A Decade Chart 2Has Economic Activity Peaked? Chart 3Our Framework Suggests A Slower Growth Momentum Ahead The view fits perfectly into our analytical framework, which has worked well in the past decade. Historically, China’s credit formation has consistently led economic activity by about six to nine months. A turning point in the credit impulse occurred last October, which suggests that economic activity should start to slow in Q2 this year (Chart 3). However, our clients countered with the following arguments, which support a notion that sequential economic growth rate can still trend higher in the next six months: Aggregate demand in Europe and the US continues to improve, while the COVID-19 resurgence in major emerging economies, such as India and Brazil, has forced their production recoveries to pause. Thus, China’s exports will remain robust and should continue to make substantial contributions to the economy (Chart 4). Infrastructure spending could get a meaningful boost when local governments speed up issuing special-purpose bonds (SPB) in Q2 and Q3. Infrastructure investment growth was relatively weak in Q1, probably the result of a slower pace in credit growth and government expenditures (Chart 5). However, a delay in local government SPB issuance in Q1 this year means more support for infrastructure investment in the rest of the year (Chart 6). Chart 4Counterpoint #1: Chinese Exports Will Stay Strong   Chart 5Slower Credit Growth Led To A Subdued Q1 Infrastructure Investment Growth     Travel restrictions imposed during the Chinese New Year weighed heavily on the service sector in Q1 (Chart 7). If China’s domestic COVID-19 cases remain well controlled, then the trend could reverse and the pent-up demand for service consumption may usher in a significant improvement in Q2 when three major public holidays occur. The service sector accounts for more than half of China’s GDP, therefore, an improvement in this sector should significantly bolster future GDP growth. Chart 6Counterpoint #2: More LG SPBs, More Spending On Infrastructure Chart 7Counterpoint #3: Service Sector Activities Will Pick Up Our Analytical Framework The viewpoints expressed by clients have not changed our cyclical view of China’s economy, since our broad analysis of Chinese business cycle already incorporates the main points that clients raised. Additionally, data such as GDP growth figures are coincident and lagging indicators, and do not explain the direction of forward-looking financial markets. The authorities will shift their policy trajectories only if the data significantly deviate from expectations. We view Q1 GDP and underlying data broadly in line with Chinese leadership’s short- and medium-term economic growth targets and, therefore, will not lead to any policy adjustment. Chart 8If Demand For Chinese Exports Stays Strong, Reform Efforts Will Intensify To our clients’ point that strong exports ahead will support China’s overall GDP growth, we regard a favorable external backdrop as a potential downside risk to the domestic economy. The willingness of Chinese authorities to pursue painful reforms is often positively correlated with global growth (Chart 8). BCA has written extensively about how China has taken advantage of a stronger export sector by increasing the pace of domestic reforms and in the past has embarked on a multi-year reform plan that weighed on growth. At the beginning of this year, Chinese policymakers were set out to “keep credit growth in line with nominal GDP growth in 2021.” Nonetheless, policymakers’ targets for credit and nominal GDP growth rates could change during the year, contingent on their perception of the broad growth outlook and unemployment. Chart 9Both Credit And Economic Growth Rates Are Moving Targets And Subject To Policy Finetuning Even if policymakers keep the country’s leverage ratio steady in 2021, which is our base case view and assuming China’s nominal GDP grows by 11%, then the credit impulse (measured by the 12-month difference in total social financing as a percentage of GDP) will likely fall to about 28% of GDP, down from 32% of GDP in 2020 (Chart 9).  The rate of credit formation increased by 13.6% in the first three months from Q1 last year, above government’s target. We expect a further pullback in credit growth in the rest of the year, to bring the annual pace at or below 12%. Construction capex, which is sensitive to both credit creation and tightening regulations in the housing sector, will likely experience a slowdown. At more than 90% of GDP, China’s economy is mainly driven by domestic demand and a weakening in the domestic economy can more than offset positive contributions from a robust export sector. Infrastructure And Services We expect infrastructure investment will grow by 4-5% this year, which is in line with its rate of expansion in 2020. However, the sequential growth in the sector in Q2 – Q4 this year will be slower than during the same period in 2020 (Chart 10). We agree that a more concentrated issuance of local government SPBs in Q2 and Q3 could help to buttress infrastructure investment. However, SPBs made up only about 15% of overall infrastructure spending in the past three years, so we are dubious that SPBs can provide the crucial support. The rest of the gap for local governments to finance their spending on infrastructure projects will need to be filled through public-private partnerships (PPP) financing, government-managed funds’ (GMFs) revenues, government budgets and bank loans. Note that only non-household medium- and long-term (MLT) bank lending showed a positive impulse so far (Chart 11). While not all of MLT loans are used for infrastructure, they have a positive correlation with investments in infrastructure projects which are generally long term in nature. Chart 10Sequential Growth In Infrastructure Investment Will Be Slower Than In Q2 – Q4 Last Year Chart 11MLT Bank Loans Have Been Supportive To Infrastructure Spending... On the other hand, the contribution of PPPs to total infrastructure spending has been plunging in recent years due to tighter regulations aimed at controlling increased risks related to local government debt (Chart 12). Depressed revenues from land sales and extended corporate tax cuts this year will also curb the ability of local governments to finance infrastructure projects (Chart 13). Chart 12...But Public-Private Partnerships Have Become Too Small To Fill The Financing Gap Chart 13Government-Managed Funds Also Face Headwinds From Falling Land Sales Finally, although the service sector accounts for 54% of China’s GDP (2019 statistic), transport, retail and accommodation, which were hardest hit by COVID-19, accounted for less than 30% of China’s tertiary GDP. This compares with a slightly larger share of tertiary GDP from finance- and housing-related sectors (financial intermediation, leasing & business services, and real estate) –the sectors that have been thriving since the second half of last year when both the equity and housing markets boomed (Chart 14). Nonetheless, it is unreasonable to expect these areas to strengthen even more in an environment where the policy has shifted to contain risks in the financial and housing arenas. The net result to tertiary GDP growth is that the deterioration in finance- and real estate-related segments will likely offset an improvement in transport, retail and accommodation. Chart 14More Than 70% Of China’s Services Sector Is Finance And Real Estate Related Investment Conclusions The ultimate question we got from almost every client meeting was: What would make us turn bullish on Chinese stocks in the next 6 to 12 months?  Chart 15Changes In Domestic Policy Dominate Chinese Stock Performance Since most monthly and quarterly economic data do not provide enough market-moving catalysts, we rely on our assessment of the changes in policy direction, such as interbank liquidity conditions and excess reserves, in addition to overall credit growth (Chart 15). We will also continue to watch for the following signs before upgrading our tactical and cyclical calls from underweight to overweight: Chart 16 shows that cyclical stocks remain depressed relative to defensives in both onshore and offshore markets, underscoring investors’ concerns about China’s economy. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards policy support and economic growth. A technical breakdown in the performance of healthcare and utility stocks relative to investable stocks would be another bullish indicator (Chart 17). These equities have historically led China’s economic activity, core inflation and stock prices by one to three months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a meaningful economic upturn in China.   Chart 16Waiting For A Telltale Sign... Chart 17...Before Upgrading Chinese Stocks   Given that the above mentioned indicators remain firmly in a risk-off mode, we maintain our view that China’s economy has reached its peak, and policy has tightened meaningfully. Our cyclical underweight position on Chinese stocks, in both absolute terms and within a global portfolio, is warranted.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights After staging a tentative rebound in the first three months of the year, the US dollar has resumed its weakening trend. We expect the greenback to drift lower over the next 12 months, as global growth momentum rotates from the US to the rest of the world, the Fed maintains its ultra-accommodative monetary stance, and the US struggles to finance its burgeoning trade deficit. China will provide adequate fiscal and monetary support for its economy, which will buoy commodity prices, the yuan, and other EM currencies. The Canadian dollar should strengthen as the Bank of Canada continues to shrink its balance sheet with the goal of lifting rates by the end of 2022. EUR/USD is on track to rise to 1.25 by year-end. The pound will strengthen against the euro. While the yen’s defensive nature will limit any gains in the currency, a cheap valuation and relatively high Japanese real rates will keep downside risks in check. Global Growth Momentum To Rotate From The US To The Rest Of The World Sizable upward revisions to US growth projections gave the US dollar a modest boost in the first quarter of 2021 (Chart 1). According to Bloomberg consensus estimates, US real GDP grew by 5.4% in the first quarter, spurred on by massive fiscal stimulus and a speedy vaccination rollout. In contrast, real GDP in the euro area, the UK, and Japan contracted (Table 1). Chart 1A Dovish Fed Kept The Dollar From Strengthening Much This Year Despite Strong US Growth Vis-À-Vis The Rest Of The World Table 1Growth In Major Advanced Countries Is Expected To Start Catching Up To The US Later This Year While economic momentum still favors the US in the second quarter, the gap with other countries will narrow dramatically. The US economy is on track to expand by 8.1% in the current quarter. Bloomberg consensus expects the euro area to grow by 7.4%, the UK by 17.4%, and Japan by 4.7%. Looking out to the third quarter, both the euro area and the UK are poised to grow faster than the US. Continental Europe, in particular, should see much stronger growth in the second half of 2021 following a sluggish start to the vaccine rollout. Enough Vaccines For All? The vaccination campaign has gotten off to a slow start in most emerging markets. The spread of more contagious Covid-19 variants has led to a surge in infections in some regions. Notably, India is reporting over 300,000 new cases a day. Matters should improve on the pandemic front for many developing economies later this year. Assuming that vaccine makers are able to achieve their production targets, the Duke University Global Health Innovation Center estimates that 12 billion vaccine doses will be produced in 2021. This would be enough to vaccinate 75% of the world’s population, close to most measures of “herd immunity.” China Will Maintain Ample Policy Support Chart 2Real Rate Differentials Moved In Favor Of The Dollar At The Long End Of The Curve In Q1, But Not At The Short End Investor concerns that the Chinese authorities are about to reverse stimulus measures are overblown. Jing Sima, BCA’s chief China strategist, expects the general government budget deficit to average 8% of GDP in 2021, largely unchanged from 2020 levels. She sees credit growth falling from 15% in 2020 to 12% this year (in line with her estimate of nominal GDP growth). Given that China’s debt-to-GDP ratio stands at 270%, credit growth of 12% would leave the outstanding stock of credit roughly 33 trillion yuan (32% of GDP) higher at the end of 2021 compared to end-2020. That is a lot of new credit formation, all of which should buoy commodity prices, the yuan, and other EM currencies. Rate Differentials Remain Dollar Bearish Despite strong US growth, US 2-year real rates have continued to decline in relation to rates abroad. Long-term yield differentials did rise in favor of the US in the first three months of the year, giving the dollar a lift. However, long-term differentials have since reversed course, which helps account for the dollar’s renewed weakness (Chart 2). The Fed’s dovish stance explains why stronger growth has given so little support to the dollar. The 10-year Treasury yield generally tracks the expected Fed funds rate two-to-three years out (Chart 3). At present, the markets are as hawkish relative to the median Fed dot as they have ever been (Chart 4). Chart 3Bond Yields Are Unlikely To Rise Much Unless The Market Lifts Its Estimate Of Where The Fed Funds Rate Will Be 2-To-3 Years Out Chart 4The Market Is Very Hawkish Relative To The Fed Dots This doesn’t mean that market expectations cannot get more hawkish from here. However, for this to happen, the Fed would need to start aggressively talking up the prospect of tapering asset purchases and accelerating the timeline to hiking rates. This does not seem probable to us. Chart 5Prime-Age Employment Remains Well Below Pre-Pandemic Levels The prime-age employment-to-population ratio is still 3.7 percentage points below pre-pandemic levels (Chart 5). Overall US employment is about 5% below where it was in January 2020. Among workers earning less than $20 per hour, employment is down more than 10% (Chart 6). While some firms have complained about a shortage of workers, this likely reflects the combination of generous unemployment benefits (which expire in September) and lingering fears about catching the virus from work (which will abate as more people are vaccinated). Just as was the case following the Great Recession – when market commentary was rife with talk about a permanent increase in “structural unemployment” – concerns that the pandemic has led to lasting labor market damage will prove to be largely unfounded.   Chart 6US Employment Still Down About 5% From Its Pre-Pandemic Levels   The Dollar Faces Balance Of Payments Pressures The dollar is not a cheap currency. It is 13% overvalued based on Purchasing Power Parity exchange rates (Chart 7). One of the consequences of the dollar’s overvaluation has been a persistent trade deficit. As Chart 8 shows, the US trade deficit in goods and services has widened sharply since early 2020. Chart 7The Dollar Is Expensive Based On Its PPP Fair Value Chart 8The Widening US Trade Deficit Excessively large budget deficits drain national savings, leading to a larger current account deficit. Hence, the dollar has usually weakened whenever the government has eased fiscal policy beyond what was necessary to close the output gap (Chart 9). Foreigners have been net sellers of Treasurys this year. To a large extent, equity inflows have supported the dollar (Chart 10). However, if growth rotates from the US to the rest of the world, non-US stock markets are likely to outperform. This could cause foreign equity inflows into the US to turn into outflows. The dollar would then need to weaken to make US stocks more attractive in foreign-currency terms. Chart 9The Dollar Usually Weakens Whenever The Government Eases Fiscal Policy Beyond What Is Necessary To Close The Output Gap Chart 10Equity Inflows Supported The Dollar This Year   Technicals Point To A Weaker Dollar For many investment decisions, being a contrarian is a smart strategy. This does not apply to trading the US dollar, however. The dollar is a high momentum currency (Chart 11). When it comes to the dollar, you want to be a trend follower. Chart 11The Dollar Is A High Momentum Currency   Chart 12 shows that a simple trading rule that bought the dollar index when it was trading above its moving average would have made money, whereas a rule that bought the index when it was below its moving average would have lost money. While trading rules using short-term moving averages work best, even long-term moving average rules yield profitable results. Chart 12ATrading The Dollar: Follow Momentum (I) Chart 12BTrading The Dollar: Follow Momentum (II)   Today, the dollar is trading below all of its various moving averages, which points to further downside for the currency. The dollar’s momentum status extends to sentiment. In general, the dollar is more likely to strengthen when sentiment is already bullish. On the flipside, the dollar is more likely to weaken when sentiment is bearish. At present, dollar sentiment is bearish, which increases the odds of further dollar weakness (Chart 13). Chart 13ABeing A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Chart 13BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II)   Chart 14Seasonality In The FX, Bond, And Equity Markets Finally, the dollar has tended to exhibit seasonal fluctuations. In general, the greenback has strengthened in the first half of the year and weakened in the second half (Chart 14). It is not entirely clear what explains this phenomenon, but it is worth noting that since 1985, almost all of the cumulative decline in Treasury yields has occurred in the back half of the year. Cyclical Currencies Are Most Likely To Strengthen Against The US Dollar Cyclical (i.e., high-beta) currencies will fare best against the US dollar over the next 12 months. In the EM space, strong global growth will benefit the Mexican peso, Chilean peso, Brazilian real, South African rand, Korean won, and the Indonesian rupiah. In the developed economy sphere, the Swedish krona, Norwegian krone, and Australian and Canadian dollars are poised to appreciate the most. We are particularly bullish on the loonie. The Bank of Canada announced on Wednesday that it will reduce the weekly pace of government bond purchases from C$4 billion to C$3 billion. Even before this announcement, the BoC’s balance sheet was shrinking following the decision to scale back repo operations and discontinue several other asset purchase programs. The BoC also indicated that it expects the Canadian economy to return to full employment in the second half of 2022, which should set the stage for the first rate hike by the end of next year. We expect EUR/USD to reach 1.25 by year-end. The British pound will strengthen to 1.50 against the dollar and 1.20 against the euro. Chart 15 shows that GBP/USD has closely tracked the rise and fall of global equities. Notably, the pound is 15% undervalued against the euro based on real 2-year interest rate differentials (Chart 16). Chart 15GBP/USD Has Closely Tracked Global Equities Chart 16The Pound Is Undervalued Against The Euro Based On Real Short-Term Interest Rate Differentials   The Japanese yen is a highly defensive currency. Hence, stronger global growth will pose a headwind to the yen. Nevertheless, the yen is quite cheap, trading at a 20% discount to its Purchasing Power Parity exchange rate (Chart 17). Moreover, real yields are higher in Japan than they are in the other major economies, reflecting ongoing deflationary pressures (Chart 18). On balance, we expect the yen to move sideways against the US dollar over the next 12 months. Chart 17The Yen Is Quite Cheap Chart 18Real Yields Are Higher In Japan Than In The Other Major Economies   Equity Implications Of A Weaker Dollar Cyclical stocks tend to outperform defensives when the dollar is weakening. To the extent that cyclicals are overrepresented in stock market indices outside the US, a weaker dollar favors non-US equities (Chart 19). Chart 19Cyclical Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 20Value Stocks Generally Do Best In A Weak Dollar Environment Value stocks also tend to do best in a weak dollar environment (Chart 20). As such, we recommend that investors overweight cyclicals, non-US, and value stocks over the next 12 months.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Highlights The Greens are likely to win control of Germany’s government in the September 26 federal elections. At least they will be very influential in the new coalition. Germany has achieved may of its long-term geopolitical goals within the EU. There is consensus on dovish monetary and fiscal policy and hawkish environmental policy. The biggest changes will come from the outside. The US and Germany have a more difficult relationship. While they both oppose Russian and Chinese aggression, Germany will resist American aggression. The Christian Democrats have a 65% chance of remaining in government which would limit the Greens’ controversial and ambitious tax agenda. The 35% chance of a left-wing coalition will frontload fiscal stimulus for the sake of recovery. The economy is looking up and a Green-led fiscal easing would supercharge the recovery. However, coalition politics will likely fail to address Germany’s poor demography, deteriorating productivity, and large excess savings. On a cyclical basis, overweight peripheral European bonds relative to bunds; EUR/USD; and Italian and Spanish stocks relative to German stocks. Feature Chart 1Germans Turn To A Young Woman And A Green Germany is set to become the first major country to be led by a green party. At very least the German election on September 26 will see an upset in which the ruling party under-performs and the Greens over-perform (Chart 1). At 30%, online betting markets are underrating the odds that Annalena Baerbock will become the first Green chancellor in 2022 – and the first elected chancellor to hail from a third party (Chart 2). The “German question” – the problem of how to unify Germany yet keep peace with the neighbors – lay at the heart of Europe for the past two centuries but today it appears substantially resolved: a peaceful and unified Germany stands at the center of a peaceful and mostly unified Europe. There are a range of risks on the horizon but this positive backdrop should be acknowledged. Chart 2Market Waking Up To Baerbock’s Bid For Chancellorship All of the likeliest scenarios for the German election will reinforce the current situation by perpetuating policies that aim for Euro Area solidarity. Even the green shift is already well underway, though a Green-led government would supercharge it. Nevertheless this year’s election is important because it heralds a leftward shift in Germany and will shape fiscal, energy, industrial, and trade policy for at least the coming four years. A left-wing sweep would generate equity market excitement in the short run – a positive fiscal surprise to supercharge the post-pandemic rebound – but over the long run it would bring greater policy uncertainty because it would cause a break with the past and possibly a structural economic shift (Chart 3). The Greens are in favor of substantial increases in taxation and regulation as well as big changes in industrial and energy policy. In the absence of a left-wing sweep, coalition politics will be a muddle and Germany’s existing policies will continue. Chart 3German Policy Uncertainty On The Rise Regardless of what happens within Germany, the geopolitical environment is increasingly dangerous. Germany will try to avoid getting drawn into the US’s great power struggles with Russia and China but it may not have a choice. Germany’s Geopolitics The difficulty of German unification stands at the center of modern European history. Because of the large and productive German-speaking population, unification in 1871 posed a security threat to the neighbors, culminating in the world wars. The peaceful German reunification after the Cold War created the potential for the EU to succeed and establish peace and prosperity on the continent. This arrangement has survived recent challenges. Germany’s relationship with the EU came under threat from the financial crisis, the Arab Spring and immigration influx, Brexit, and President Trump’s trade tariffs. But in the end these events cemented the reality that German and Europe are strengthening their bonds in the face of foreign pressures. Germany achieved what it had long sought – preeminence on the continent – by eschewing a military role, sticking to France economically, and avoiding conflict with Russia. Since Germany has achieved many of its long-sought strategic objectives it has not fallen victim to a nationalist backlash over the past ten years like the US and United Kingdom. However, Germany is not immune to populism or anti-establishment sentiment. The two main political blocs, the Christian Democrats and the Democratic Socialists, have suffered a loss of popular support in recent elections, forcing them into a grand coalition together. Anti-establishment feeling in Germany has moved the electorate to the left, in favor of the Greens. The Greens have risen inexorably over the past decade and have now seized the momentum only five months before an election (Chart 4). Yet the Greens in Germany are basically an establishment political party. They participate in 11 out of 16 state governments and currently hold the top position in Baden-Württemberg, Germany’s third most populous and productive state. From 1998-2005 they participated in government, getting their hands dirty with neoliberal structural reforms and overseas military deployments. Moreover the Greens cannot rule alone but will have to rule within a coalition, which will mediate their more controversial policies. Chart 4Greens Surge, Christian Democrats Falter Today Germany is in lock step with France and the EU by meeting three key conditions: full monetary accommodation (the German constitutional court’s challenges to the European Central Bank are ineffectual), full fiscal accommodation (Chancellor Angela Merkel agreed to joint debt issuance and loose deficit controls amid the COVID-19 crisis as well as robust green energy policies), and full security accommodation (German rearmament exists within the context of NATO and European security aspirations are undertaken in lock-step with the French). These conditions will not change in the 2021 election even assuming that the Greens take power at the head of a left-wing coalition. Bottom Line: Germany has virtually achieved its grand strategic aims of unifying and ruling Europe. No German government will challenge this situation and every German government will strive to solidify it. The greatest risks to this setup stem from abroad rather than at home. The Return Of The German Question? Germany’s geopolitical position can be summarized by Chart 5, which shows popular views toward different countries and institutions. The Germans look positively upon the EU and global institutions like the United Nations and less so NATO. They look unfavorably upon everything else. They take an unfavorable view toward Russia, but not dramatically so, which shows their lack of interest in conflict with Russia – they do not want to be the battleground or the ramparts of another major European war. They dislike the United States and China even more, and equally. Even if attitudes toward the US have improved since the 2020 election the net unfavorability is telling. Chart 5Germany More Favorable Toward Russia Than US? Since the global financial crisis, and especially Russia’s invasion of Ukraine in 2014, Germany has built up its military. This buildup is taking place under the prodding of the United States and in step with NATO allies, who are reacting to Russia’s military action to restore its sphere of influence in the former Soviet space (Chart 6). Germany’s military spending still falls short of NATO’s 2% of GDP target, however. It will not be seen as a threat to its neighbors as long as it remains integrated with France and Europe and geared toward deterring Russia. Chart 6Germany And NATO Increase Military Spending Chart 7Watch Russo-German Relations For Cracks In Europe’s Edifice Russia’s aggressiveness should continue to drive the Germans and Europeans into each other’s arms. This could change if Putin pursues diplomacy over military coercion, for then he could split Germany from eastern Europe. The possibility is clear from Russia’s and Germany’s current insistence on completing the Nord Stream 2 pipeline despite American and eastern European objections. The pipeline is set to be completed by September, right in time for the elections – in no small part because the Greens oppose it. If the US insists on halting the pipeline then a crisis will erupt with Russia that will humiliate Merkel and the Christian Democrats. But the US may refrain from doing so in the face of Russian military threats (odds are 50/50). The Russian positioning over 100,000 troops on the border with Ukraine this year – and now reportedly ordering them to return to base by May 1 – amounts to a test of Russo-German relations. Putin can easily expand the Russian footprint in Ukraine and tensions will remain elevated at least through the Russian legislative elections in September. Germans would respond to another invasion with sanctions, albeit likely watering down tougher sanctions proposed by the Americans. What would truly change the game would be a Russian conquest of all of Ukraine. This is unlikely – precisely because it would unite Germany, the Europeans, and the Americans solidly against Russia, to its economic loss as well as strategic disadvantage (Chart 7). China’s rise should also keep Germany bound up with Europe. The Germans fear China’s technological and manufacturing advancement, including Chinese involvement in digital infrastructure and networks. The Greens are critical of the way that carbon-heavy Chinese goods undercut the prices of carbon-lite German goods. Baerbock favors carbon adjustment fees, a pretty word for tariffs. However, the Germans want to maintain business with China and are not very afraid of China’s military. Hence there is a risk of a US-German split over the question of China. If Germany should consistently side with Russia and China over US objections then it risks attracting hostile attention from the US as well as from fellow Europeans, who will eventually fear that German power is becoming exorbitant by forming relations with giants outside the EU. But this is not the leading risk today. The US is courting Germany and seeking to renew the trans-Atlantic alliance. Meanwhile Germany needs US support against Russia’s military and China’s trade practices. US-German relations will improve unless the US forces Germany into an outright conflict with the autocratic powers. Bottom Line: The US and Germany have a more difficult relationship now than in the past but they share an interest in deterring Russian aggression and Chinese technological and trade ambitions. Biden’s attempt to confront these powers multilaterally is limited by Germany’s risk-aversion. Scenarios For The 2021 Election There are several realistic scenarios for the German election outcome. Our expectation that the Greens will form a government stems from a series of fundamental factors. Opinion polling has now clearly shifted in favor of our view, with the Greens gaining the momentum with only five months to go. Grouping the political parties into ideological blocs shows that the race is a dead heat. Our bet is that momentum will break in favor of the opposition Greens, which we explain below. Meanwhile the Free Democrats should perform well, stealing votes from the Christian Democrats. The right-wing Alternative für Deutschland (AfD), while not performing well, is persistent enough to poach some votes from the Christian Democrats. These are “lost” votes to the conservatives as none of the parties will join it in a coalition (Chart 8). Chart 8Germany's Median Voters Shifts To the Left The Christian Democrats bear all the signs of a stale and vulnerable government. They have been in power for 16 years and their performance in state and federal elections has eroded recently, including this year (Table 1). The public is susceptible to the powerful idea that it is time for a change. Chancellor Merkel’s approval rating is still around 60%, but in freefall, and her successful legacy is not enough to save her party, which is showing all the signs of panic: succession issues, indecision, infighting, corruption scandals. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated (Table 2).1 Table 1AChristian Democrats Fall, Greens Rise, In Recent State Elections Table 1BChristian Democrats Fall, Greens Rise, In Recent State Elections Table 2Policy Platforms Of The Green Party The fact that Christian Democrats and their Bavarian sister party, the Christian Social Union, saw such a tough race for chancellor candidate is an ill omen. Moreover the party’s elites went for the safe choice of Merkel’s handpicked successor, Armin Laschet, over the more popular Markus Soeder (Chart 9), in a division that will likely haunt the party later this year. Chart 9Christian Democrats And Christian Social Union Divided Ahead Of Election Laschet has received a bounce in polls with the nomination but it will be temporary. He has not cut a major figure in any polling prior to now. Chart 10Dissatisfaction Points To Government Change He has quarreled openly with Merkel and the coalition over pandemic management. He was not her first choice of successor anyway – that was Annagret Kramp-Karrenbauer, who fell from grace due to controversy over the faintest hint of cooperation with the AfD. There is a manifest problem filling Merkel’s shoes. Even more important than coalition infighting is the fact that Germany, like the rest of the world, has suffered a historic shock to its economy and society. The pandemic and recession were then aggravated by a botched vaccine rollout. General dissatisfaction is high, another negative sign for the incumbent party (Chart 10). Of course, the election is still five months away. The vaccine will make its way around, the economy will reopen, and consumers will look up – see below for the very positive macro upturn that Germany should expect between now and the election. Voters have largely favored strict pandemic measures and Merkel will have long coattails. This Christian Democrats and Christian Social Union have ruled modern Germany for all but 15 years and have not fallen beneath 33% of the popular vote since reunification. The Greens have frequently aroused more energy in opinion polling than at the voting booth. With these points in mind, we offer the following election scenarios with our subjective probabilities: Green-Red-Red Coalition – Greens rule without Christian Democrats – 35% odds. Green-Black Coalition – Greens rule with Christian Democrats – 30% odds. Black-Green Coalition – Christian Democrats rule with Greens – 25% odds. Grand Coalition (Status Quo) – Christian Democrats rule without Greens – 10% odds. Our subjective probabilities are based on the opinion polls and online betting cited above but adjusted for the Greens’ momentum, the Christian Democrats’ internal divisions, the “time for change” factor, and the presence of a historic exogenous economic and social shock. Geopolitical surprises could occur before the election but they would most likely reinforce the Greens, since they have taken a hawkish line against Russia and China. Bottom Line: The Greens are likely to lead the next German government but at very least they will have a powerful influence. Policy Impacts Of Election Scenarios The makeup of the ruling coalition will determine the parameters of new policy. Fiscal policy will change based on the election outcome – both spending and taxes. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated.2 The Greens’ idea is to “steer” the rebuilding process through environmental policy. But if the left lacks a strong majority then the Greens’ more controversial and punitive measures will not get through. Transformative policies will weigh heavily on the lower classes (Chart 11). Chart 11Ambitious Climate Policy Will Face Resistance The policy dispositions of the various chancellor candidates help to illustrate Germany’s high degree of policy consensus. Table 3 looks at the candidates based on whether they are “hawkish” (active or offensive) or “dovish” (passive or defensive) on a given policy area. What stands out is the agreement among the different candidates despite party differences. Nobody is a fiscal or monetary hawk. Only Baerbock can be classified as a hawk on trade.3 Nobody is a hawk on immigration. Nearly everyone is a hawk on fighting climate change. And attitudes are turning more skeptical of Russia and China, though not outright hawkish. Table 3Policy Consensus Among German Chancellor Candidates Germany will not abandon its green initiatives even if the Greens underperform. The current grand coalition pursued a climate package due to popular pressure even with the Greens in opposition. Germans are considerably more pro-environment even than other Europeans (Chart 12). The green shift is also happening across the world. The US is now joining the green race while China is doubling down for its own reasons. See the Appendix for current green targets and measures, which have been updated in the wake of a slew of announcements before Biden’s Earth Day climate summit on April 22-23. Chart 12Germans Care Even More About Environment Than Other Europeans Any coalition will raise spending more than taxes since it will be focused on post-COVID economic recovery. There has been a long prelude to Germany’s proactive fiscal shift – it has staying power and is not to be dismissed. A Christian Democratic coalition would try to restore fiscal discipline sooner than otherwise but there is only a 5% chance that it will have the power to do so according to the scenarios given above. The rest of Europe will be motivated to spend aggressively while EU fiscal caps are on hold in 2022, especially if the German government is taking a more dovish turn. Even more than the US and UK, Germany is turning away from the neoliberal Washington Consensus. But Germans are not experiencing any kind of US-style surge of polarization and populism. At least not yet. It may be a risk over the long run, depending on the fate of the Christian Democrats, the AfD, and various internal and external developments. Bottom Line: Germany has a national consensus that consists of dovish monetary, fiscal, trade, and immigration policies and hawkish (pro-green) environmental policy. Germany is turning less dovish on geopolitical conflicts with Russia and China. Given that a coalition government is likely, this consensus is likely to determine actual policy in the wake of this year’s election. A few things are clear regardless of the ruling coalition. First, Germany is seeking domestic demand as a new source of growth, to rebalance its economy and deepen EU integration. Second, Germany is accelerating its green energy drive. Third, Germany cannot accept being in the middle of a new cold war with Russia. Fourth, Germany has an ambivalent policy on China. Germany’s Macro Outlook Even before considering the broader fiscal picture, the outlook for German economic activity over the course of the coming 12 to 24 months was already positive. Our base case scenario for the September election, which foresees a coalition government led by the Green Party, only confirms this optimistic view. However, Germany is still facing significant long-term challenges, and, so far, there has not been a political consensus to address these structural headwinds adequately. The Greens offer some solutions but not all of their proposals are constructive and much will depend on their parliamentary strength. Peering Into The Near-Term… Germany’s economy is set to benefit from the continued recovery of the global business cycle, which is a view at the core of BCA Research’s current outlook.4 Germany remains a trading and manufacturing powerhouse, and thus, it will reap a significant dividend from the continued global manufacturing upswing. Manufacturing and trade amount to 20% and 88% of Germany’s GDP, the highest percentage of any major economy. Alternatively, according to the OECD, foreign demand for German goods accounts for nearly 30% of domestic value added, a share even greater than that for a smaller economy like Korea (Chart 13). Moreover, road vehicles, machinery and other transport equipment, as well as chemicals and related products, account for 53% of Germany’s exports. These products are all particularly sensitive to the global business cycle. They will therefore enhance the performance of the German economy over the next two years. Trade with the rest of Europe constitutes another boost to Germany’s economy going forward. Shipments to the euro area and the rest of the EU account for 34% and 23% of Germany’s exports, or 57% overall. Right now, the lagging economy of Europe is a handicap for Germany; however, Europe has more pent-up demand than the US, and the consumption of durable goods will surge once the vaccination campaign progresses further (Chart 14). This will create a significant boon for Germany, since we expect European consumption to pick up meaningfully over the coming 12 to 18 months.5 Chart 13Germany Depends On Global Trade Chart 14Europe Has More Pent-Up Demand Than The US Chart 15Vaccination Progress Domestic forces also point toward a strong Germany economy, not just foreign factors. The pace of vaccination is rapidly accelerating in Germany (Chart 15). The recent announcement of 50 million additional doses purchases for the quarter and up to 1.8 billion more doses over the next two years by the EU points to further improvements. A more broad-based vaccination effort will catalyze underlying tailwinds to consumption. German household income will also progress significantly. The Kurzarbeit program was instrumental in containing the unemployment rate during the crisis, which only peaked at 6.4% from 5% in early 2020. However, the program could not prevent a sharp decline in total hours worked of 7%, since by definition, it forced six million employees to work reduced hours (Chart 16). One of the great benefits of the program is that it prevents a rupture of the link between workers and employers. Thus, the economy suffers less frictional unemployment as activity recovers and household income does not suffer long lasting damage. Meanwhile, the German government is likely to extend the support for households and businesses as a result of the delayed use of the debt-brake. The Greens propose revising the debt brake rather than restoring it in 2022 like the conservatives pledge to do. Chart 16Kurtzarbeit Saved The Day The balance-sheet strength of German households means that they will have the wherewithal to spend these growing incomes. Residential real estate prices are rising at an 8% annual pace, which is pushing the asset-to-disposable income ratio to record highs. Meanwhile, the debt-to-assets ratio, and the level of interest rates are also very low, which means that the burden of serving existing liabilities is minimal (Chart 17). In this context, durable goods spending will accelerate, which will lift overall cyclical spending, even if German households do not spend much of the EUR120 billion in excess savings built up over the past year. As Chart 18 shows, while US durable goods spending has already overtaken its pre-COVID highs, Germany’s continues to linger near its long-term trend. Thus, as the economy re-opens this summer, and income and employment increase, the concurrent surge in consumer confidence will allow for a recovery in cyclical spending. Chart 17Strong Household Balance Sheets Chart 18Germany Too Has More Pent-up Demand Than The US Chart 19Positive Message From Many Indicators Various economic indicators are already pointing toward the coming German economic boom.Manufacturing orders are strong, and economic sentiment confidence is rising across most sectors. Meanwhile, consumer optimism is forming a trough, and new car registrations are climbing rapidly. Most positively, the stocks of finished goods have collapsed, which suggests that production will be ramped up to fulfill future demand (Chart 19). Bottom Line: The German economy is set to accelerate in the second half of the year and into 2022. As usual, Germany will enjoy a healthy dividend from robust global growth, but the expanding vaccination program, as well durable employee-employer relations, strong household balance sheets, and significant pent-up demand for durable goods will also fuel the domestic economy. Our base case scenario that fiscal policy will remain accommodative in the wake of a political shift to the left in Berlin in September will only supercharge this inevitable recovery. … And The Long-Term In contrast to the bright near-term perspective, the long-term outlook for the German economy remains poor. The policies of any new ruling coalition are unlikely to address the problems of Germany’s poor demography, deteriorating productivity, and large excess savings. There is potential for a productivity boost in the context of a global green energy and high-tech race but for now that remains a matter of speculation. The most obvious issue facing Germany is its ageing population, counterbalanced by its fertility rate of only 1.6. Over the course of the next three decades, Germany’s dependency ratio will surge to 80%, driven by an increase in the elderly dependency ratio of 20% (Chart 20). The working age population is set to decline by 18% by 2050, which will curtail potential GDP growth. The outlook for German productivity growth is also poor. Germany’s productivity growth has been in a long-term decline, falling from 5% in 1975 to less than 1% in 2019. Contrary to commonly-held ideas, from 1999 to 2007, German labor productivity growth has only matched that of France or Spain; since 2008, it has lagged behind these two nations, although it has bested Italy. One crucial reason for Germany’s uninspiring productivity performance is a lack of investment. Some of this reflects the country’s austere fiscal policy. For example, in 2019, Germany’s public investment stood at 2.4% of GDP, which compares poorly to the OECD’s average of 3.8%, or even to that of the US, where public investment stood at 3.6% of GDP. This poor statistic does not even account for the depreciation of the German public capital stock. Since the introduction of the euro, net public investment has averaged 0.03% of GDP. The biggest problem remains at the municipal level. From 2012 to 2019, federal and state level net investment averaged 0.2% of GDP, while municipal net investment subtracted 0.2% of GDP on average. Hopefully, the new government will be able to address this deficiency of the German economy. The Greens are most proactive but they will face obstacles. The bigger problem for German productivity is corporate capex. Corporate investments have been low in this country. Since the introduction of the euro, the contribution of capital intensity to productivity in Germany has equaled that of Italy and has underperformed France and Spain. As a result, the age of the German capital stock is at a record high and stands well above the US or Eurozone average (Chart 21). Chart 20Germany Has Poor Demographics Chart 21Germany's Capital Stock Is Ageing The make-up of Germany’s capex aggravates the productivity-handicap. According to a Bundesbank study, the contribution to labor productivity from information and communication technology (ICT) capital spending has averaged 0.05 percentage points annually from 2008 to 2012. On this metric, Germany lagged behind France and the US, but still bested Italy. From 2013 to 2017, the contribution of ICT investment to productivity fell to 0.02 percentage points, still below France and the US, but in line with Italy. Looking at the absolute level of ICT or knowledge-based capital (KBC) investment further highlights Germany’s challenge. In 2016, total investment in ICT equipment, software and database, R&D and intellectual property products, and other KBC assets (which include organizational capital and training) represented less than 8% of GDP. In France, the US, or Sweden, these outlays accounted for 11%, 12%, and 13% of GDP, respectively (Chart 22, top panel). This lack of investment directly hurts Germany’s capacity to innovate. The bottom panel of Chart 22 shows that, for the eight most important categories of ICT patents (accounting for 80% of total ICT patents), Germany remarkably lags behind the US, Japan, Korea, or China. Chart 22Germany Lags In ICT investment A major source of Germany’s handicap in ICT and KBC investment comes from small businesses, which have been particularly reluctant to deploy capital. A study by the OECD shows that, between 2010 and 2019, the gap of ICT tools and activities adoption between Germany’s small and large companies deteriorated relative to the OECD average (Chart 23). The lack of venture capital investing probably exacerbates these problems. In 2019, venture capital investing accounted for 0.06% of Germany’s GDP. This is below the level of venture investing in France or the UK (0.08% and 0.1% of GDP, respectively), let alone South Korea, Canada, Israel, or the US (0.16%, 0.2%, 0.4% and 0.65%, respectively). The Greens claim they will create new venture capital funds but their capability in this domain is questionable. Chart 23The Lagging ICT Capabilities Of Small German Businesses Since Germany’s productivity growth is likely to remain sub-par compared to rest of the OECD and to lag behind even that of France or the UK, the only way for Germany to protect its competitiveness will be to control costs. This means that Germany cannot allow its recent loss of competitiveness to continue much further (Chart 24). Thus, low productivity growth will limit Germany’s real wages. Chart 24Germany's Competitiveness Is Declining This wage constraint will negatively impact consumption. Beyond a pop over the coming 12 to 24 months, German consumption is likely to remain depressed, as it was in the first decade and a half of the century, following the Hartz IV labor market reforms that also hurt real wages. The Greens for their part aim to boost welfare payments, raise the minimum wage, and reduce enforcement of Hartz IV. Bottom Line: German excess savings will remain wide on a structural basis. Without a meaningful pick-up in capex, German nonfinancial businesses will remain net lenders. Meanwhile, households that were worried about their financial future in a world of low real-wage growth will also continue to save a significant share of their income. Consequently, the excess savings Germany developed since the turn of the millennia are here to stay (Chart 25). In other words, Germany will continue to sport a large current account surplus and exert a deflationary influence on Europe and the rest of the world. The policy prescribed by the various parties contesting the September election will not necessarily result in new laws that will reverse the issues of low capex and low ICT investment. The Greens will worsen the over-regulation of the economy. Barring a policy revolution that succeeds in all its aims (a tall order), we can expect more of the same for Germany – that is, a slowly declining economy. Chart 25Too Much Savings, Not Enough Investments Chart 26Germany Scores Well On Renewable Power That being said, some bright spots exist. Germany is becoming a leader in renewable energy, and it can capitalize on the broadening of this trend to enlarge its export market (Chart 26). Investment Implications Bond Markets The economic outlook for Germany and the euro area at large is consistent with the underweighting of German bunds within European fixed-income portfolios. Bunds rank among the most expensive bond markets in the world, which will make them extremely vulnerable to positive economic surprise in Europe later this year, especially if Germany’s fiscal policy loosens up further in the wake of the September election (Chart 27). Moreover, easier German fiscal policy should help European peripheral bonds, especially the inexpensive Italian BTPs that the ECB currently buys aggressively. Thus, we continue to overweight BTPs, and add Greek and Portuguese bonds to the list. Chart 27German Bunds Are Expensive Chart 28German Yields Already Embed Plenty Pessimism About Europe Relative to US Treasurys, the outlook for Bunds is more complex. On the one hand, the ECB will not tighten policy as much as the Fed later this cycle; moreover, European inflation is likely to remain below US levels this year, as well as through the business cycle. On the other hand, Bunds already embed a significantly lower real terminal rate proxy and term premium than Treasury Notes (Chart 28). Netting it all out, BCA Research Global Fixed Income Strategy service believes Bunds should outperform Treasurys this year, because they have a lower beta, which is a valuable feature in a rising yield environment.6 We will closely monitor risks around this view, because it is likely that the European economic recovery will be the catalyst for the next up leg in global yields, in which case German bunds could temporarily underperform. On a structural basis, as long as Germany’s productivity issues are not addressed by Berlin, German Bunds are likely to remain an anchor for global yields. Germany will remain awash in excess savings, which will act as a deflationary anchor, while also limiting the long-term upside for European real rates. Excess savings results in a large current account surplus; thus, Germany will continue to export its savings abroad and act as a containing factor for global yields. The Euro The medium-term outlook points to significant euro upside. Our expectation of a European and German positive growth surprise over the coming 12 months is consistent with an outperformance of the euro. The fact that investors have been moving funds out of the Eurozone and into the US at an almost constant rate for the past 10 years only lends credence to this argument (Chart 29). Our view on Germany’s fiscal policy contributes to the euro’s luster. Greater German budget deficits help European economic activity and curtail risk premia across the Eurozone. This process is doubly positive for the euro. First, lower risk premia in the periphery invite inflows into the euro area, especially since Greek, Portuguese, Italian, or Spanish yields offer better value than alternatives. Second, stronger growth and lower risk premia relieve pressure on the ECB as the sole reflator for the Eurozone. At the margin, this process should boost the extremely depressed terminal rate proxy for Europe and help EUR/USD. Robust global economic activity adds to the euro’s appeal, beyond the positive domestic forces at play in Europe. The dollar is a countercyclical currency; thus, global business cycle upswings coincide with a weak USD, which increases EUR/USD’s appeal. Nonetheless, if the boost to global activity emanates from the US, then the dollar can strengthen. This phenomenon was at play in the first quarter of 2021. However, the global growth leadership is set to move away from the US over the next 12 months, which implies that the normal inverse relationship between the dollar and global growth will reassert itself to the euro’s benefit. The European balance of payments dynamics will consolidate the attraction of the euro. Germany’s and the Eurozone’s current account surplus will remain wide, especially in comparison to the expanding twin deficit plaguing the US. Beyond the next 12 to 24 months, the lack of structural vigor of Germany’s and Europe’s economy is likely to shift the euro into a safe-haven currency, like the yen and the Swiss franc. A strong balance of payments and low interest rates (all symptoms of excess savings) are the defining features of funding currencies, and will be permanent attributes of the euro area if reforms do not address its productivity malaise. The Eurozone’s net international position is already rising and its low inflation will put a structural upward bias to the Euro’s purchasing power parity estimates (Chart 30). Those developments have all been evident in Japan and Switzerland, and will likely extinguish the euro’s pro-cyclicality as time passes. Chart 29Investors Already Underweight European Assets Chart 30Upward Bias In The Euro's Fair Value Chart 31Germany Has Not Outperformed The Rest Of The Eurozone German Equities In absolute terms, the DAX and German equities still possess ample upside over the next 12 to 24 months. BCA Research is assuming a positive stance on equities, and a high beta market like Germany stands to benefit.7 Moreover, the elevated sensitivity to global economic activity of German equities accentuate their appeal. BCA Research likes European stocks, and German ones are no exception.8 The more complex question is how to position German equities within a European stock portfolio. After massively outperforming from 2003 to 2012, German equities have moved in line with the rest of the Eurozone ever since (Chart 31). Moreover, German equities now trade at a discount on all the major valuation metrics relative to the rest of the Eurozone (Chart 31, bottom panel). The global macro forces that dictate the outlook for German equities relative to the rest of the Eurozone are currently sending conflicting messages. On the one hand, German equities normally outperform when commodity prices rally or when the euro appreciates (Chart 32). On the other hand, however, German equities also underperform when global yields rise, or following periods when Chinese excess reserves fall, such as what we are witnessing today. With this lack of clarity from global forces, the answer to Germany’s relative performance question lies within European economic dynamics. Germany is losing competitiveness relative to the rest of the Eurozone (Chart 24 page 22) which suggests that German stocks will benefit less than their peers from a stronger euro in comparison to their performance in the last decade. Moreover, German equities outperform when the German manufacturing PMI increases relative to that of the broad euro area. The gap between the German and euro area manufacturing PMI stands near record highs and is likely to narrow as the rest of the Eurozone catches up. This should have a bearing on the performance of German stocks (Chart 33). Chart 32Mixed Global Backdrop For Germany's Relative Performance Chart 33A European Economic Catch-Up Would Hurt German Equities Finally, sectoral dynamics may prove to be the ultimate arbiter. Table 4 highlights the limited difference in sectoral weightings between Germany and the rest of the Eurozone, which helps explain the stability in the relative performance over the past nine years. However, the variance is greater between Germany and specific European nations. In this approach, BCA’s negative stance on growth stocks correlates with an overweight of Germany relative to the Netherlands. Moreover, our positive outlook on financials and bond yields suggests that Germany should underperform Italian and Spanish stocks. Table 4Sectoral Breakdown Across Europe Major Bourses   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Appendix: Global Climate Policy Commitments Footnotes 1 See Matthew Karnitschnig, "German Conservatives Mired In ‘The Swamp,’" Politico, March 24, 2021, politico.eu. 2 The Greens are interested in a range of taxes, including a carbon tax, a digital services tax, and a financial transactions tax. They are also interested in industrial quotas requiring steel and car makers to sell a certain proportion of carbon-neutral steel and electric vehicles. See an excellent interview with Ms. Baerbock in Ileana Grabitz and Katharina Schuler, "I don’t have to convert the SUV driver in Prenzlauer Berg," Zeit Online, January 2, 2020, zeit.de. 3 See her comments to Zeit Online. 4 Please see BCA Research Global Investment Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 5 Please see BCA Research European Investment Strategy Special Report "A Temporary Decoupling", dated April 5, 2021, available at eis.bcareseach.com. 6 Please see BCA Research Global Fixed Income Strategy Strategy Report "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcareseach.com. 7 Please see BCA Research Global Income Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 8 Please see BCA Research European Income Strategy Strategy Report "Time And Attraction", dated April 12, 2021, available at eis.bcareseach.com.

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Duration: The pace of rate hikes currently priced into the market is reasonable. However, we see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: MBS remain unattractive compared to other US spread products. But within an underweight allocation to MBS, an up-in-coupon bias makes sense. Inflation: Year-over-year CPI inflation was pushed higher by base effects in March, but the report also showed evidence of mounting inflationary pressures beyond simple base effects. Feature After a sizeable drop last Thursday, Treasury yields are now significantly off their recent highs. The 10-year Treasury yield peaked at 1.74% on March 31st but ended last week at only 1.59%. What makes the drop puzzling is that yields are down despite a string of very strong US economic data (Chart 1). This recent development bears a resemblance to the famous 2004/05 bond conundrum when Fed Chairman Alan Greenspan struggled to understand why long-maturity Treasury yields were falling even as the Fed lifted short rates.1 Today, investors are also struggling to understand why long-maturity Treasury yields are falling, only this time the “conundrum” is that they are falling in the face of strong economic data. From our perch, both conundrums have the same answer: The market has already discounted a lot of the news. On June 29th, 2004 – the day before the first rate hike of that cycle – the overnight index swap (OIS) curve was priced for 243 bps of Fed rate hikes for the following 12 months. The Fed went on to deliver 200 bps of rate hikes during that timeframe, slightly less than the market expected. In that environment it is entirely consistent that bond yields should fall (Chart 2). Chart 1Yields Down On Strong Data Chart 2The 2004/05 Bond Conundrum Today, the OIS curve is priced for the Fed to lift rates off the zero bound in December 2022 and for a total of 86 bps of rate hikes by the end of 2023 (Chart 3). Given the Fed’s new Average Inflation Targeting regime, this sort of rate hike cycle will only be achieved if there is a very strong US economic recovery. The incoming US data are so far confirming that narrative but haven’t been strong enough to move rate expectations even higher. Chart 3Market Priced For December 2022 Liftoff As we wrote in last week’s report, we think that the market’s current rate hike expectations look reasonable.2 However, we see a meaningful risk that they could move higher in the coming months as the rapid US economic recovery continues and the Fed starts to back away from its extremely dovish messaging. Chart 4US Will Hit 75% Vaccination Well Before September For example, Fed Chair Jay Powell has said repeatedly that it is too soon to talk about tapering the Fed’s asset purchases. We worry, however, that this tone might be giving investors a false sense of security. If the economic recovery continues at its current pace, we fully expect the Fed to start talking about tapering this year and to begin the process either by the end of 2021 or in early 2022. Last week, St. Louis Fed President Jim Bullard said he would be comfortable starting discussions about tapering when 75%-80% of the US population has been vaccinated. We estimate that if vaccinations continue at a linear pace, we will hit 75% vaccination by September (Chart 4). Given the exponential trend in vaccinations so far, we are likely to reach 75% well before September. The bottom line is that we see the pace of rate hikes currently priced into the market as reasonable. However, we also see strong odds that market expectations will move higher in the coming months, the result of continued strong economic data and the Fed starting to talk about tapering its asset purchases. Investors should maintain below-benchmark portfolio duration. MBS: Stay Up In Coupon Unsurprisingly, the reflation trade has been beneficial for risk assets. Within US fixed income, spread products have generally outperformed Treasuries since bond yields bottomed last August. However, certain spread sectors have fared better than others. Agency Mortgage-Backed Securities, for example, have not done that well. Conventional 30-year Agency MBS have only outperformed a duration-matched position in Treasury securities by 73 bps since bond yields bottomed on August 4th, 2020 (Chart 5). This compares to 446 bps of outperformance for Aaa-rated corporates, 342 bps of outperformance for Aa-rated corporates (Chart 5, panel 2) and 232 bps of outperformance for Agency CMBS (Chart 5, panel 3). Only notoriously low-risk Aaa-rated consumer ABS have delivered less outperformance than Agency MBS (Chart 5, bottom panel). While Agency MBS have not performed well overall, certain segments of the coupon stack have delivered decent excess returns. Specifically, higher coupon MBS have performed much better than low coupon MBS during the recent back-up in yields. Since last August, 4% coupon MBS have outperformed duration-matched Treasuries by 176 bps and 4.5% coupons have outperformed by 257 bps. Meanwhile, 2.5% coupons have underperformed by 10 bps and 3% coupons have underperformed by 15 bps (Chart 6). Chart 5Spread Product Performance Since Trough In Bond Yields Chart 6Favor Premium Coupons In Rising Rate Environment The divergent performance between high and low coupons is easily explained by the risk characteristics of those bonds. Looking at the difference between the 2.5% and 4% coupons, for example, we see that the 2.5% coupons have significantly higher duration and significantly lower convexity (Chart 6, bottom 2 panels). The higher duration means that rising yields hurt 2.5% coupons more and the lower convexity means that rising yields will cause the gap between 2.5% coupon duration and 4% coupon duration to widen further. In short, a rising yield environment is terrible for low-coupon MBS. Conversely, high duration and low convexity are desirable attributes in a falling yield environment. If bond yields fall meaningfully going forward, then low-coupon MBS will outperform the high coupons. Chart 7A shows how option-adjusted spread (OAS) varies with duration across the conventional 30-year Agency MBS coupon stack. We see that the lowest coupons have the highest durations and the lowest OAS. Premium coupons have low durations and high OAS. Chart 7AAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Duration Chart 7B shows how OAS varies with convexity across the coupon stack. Here we see that the 2%, 2.5% and 3% coupons have the most negative convexities. This makes sense as those coupons are closest to the current mortgage rate of 3.04%. A further increase in the mortgage rate would make those coupons less likely to refinance, causing durations to extend meaningfully. Conversely, a drop in the mortgage rate would lead to greater refinancings for those coupons, causing durations to shorten. Notice that 1.5% coupon MBS have relatively high convexity. This is because refinancing is already unattractive for those bonds, and the duration of the 1.5% index has already extended. Chart 7BAgency MBS 30-Year Conventional Coupon Stack: OAS vs. Convexity Given our view that US Treasury yields will be flat-to-higher for the next 6-12 months, we recommend an up-in-coupon bias within Agency MBS. Specifically, the 2%, 2.5% and 3% coupons have the most scope for duration extension in a rising yield environment and should be avoided. The 4% and 4.5% coupons, on the other hand, are less negatively convex and are better able to weather the storm of rising bond yields. In a flat bond yield environment, the best performing coupons are likely to be those with the widest OAS. This makes the 4% and 4.5% coupons look much more attractive than the 1.5% coupons, even though they have similar convexities. Overall, we recommend owning the 4% and 4.5% coupons within the conventional 30-year Agency MBS coupon stack and avoiding the 2%, 2.5% and 3% coupons. One final point worth making is that we also continue to recommend an underweight allocation to MBS within a US bond portfolio. That is, though higher coupon MBS look better than the low coupons, the entire sector looks unattractive compared to alternatives like consumer ABS, Agency CMBS and even investment grade corporate bonds. Chart 8 shows a version of our Excess Return Bond Map, a visual guide that is useful for quickly assessing the risk/reward trade-off between different US spread products.3 The Map shows OAS as a measure of expected return on the Y-axis, and a proprietary risk measure called the “Risk Of Losing 100 Bps” on the X-axis. A higher number on the X-axis indicates less risk of losing 100 bps and vice-versa. Chart 8Excess Return Bond Map Our Bond Map makes it clear that only 4% and 4.5% coupon MBS come close to offering a risk/reward balance that is comparable to other spread sectors. MBS coupons below 4% offer far too little expected return given the amount of risk. Bottom Line: Remain underweight MBS within a US bond portfolio, but favor 4% and 4.5% coupons over 2%, 2.5% and 3% coupons within the Agency MBS coupon stack. March CPI More Than A Base Effect It was well known heading into last week’s March CPI release that the year-over-year inflation number was going to be very strong. This is due to base effects that will persist through to the end of May. That is, 12-month inflation is bound to rise as the negative monthly inflation prints from March, April and May 2020 fall out of the 12-month rolling sample. Year-over-year inflation numbers did indeed rise sharply in March (Chart 9). 12-month headline CPI jumped from 1.68% to 2.64% and 12-month core CPI increased from 1.28% to 1.65%. Base effects exert less influence over the trimmed mean CPI, and that index rose only from 2.04% to 2.12%. The gap between 12-month core CPI and 12-month trimmed mean CPI remains wide, but it should close by May when the impact from last year’s base effects is exhausted (Chart 9, bottom panel). Chart 9Annual Inflation Chart 10Monthly Inflation But base effects were only part of the story last week. Month-over-month inflation also came in very strong for the headline, core and trimmed mean measures. Headline CPI rose 0.62% in March, core CPI rose 0.34% and the trimmed mean rose 0.24% (Chart 10). To put those numbers in context, if those monthly prints are repeated in April and May, 12-month headline CPI will rise to 4.75% by May and 12-month core CPI will rise to 2.79%. Even if we assume more typical 0.15% inflation rates for April and May, we would still expect 12-month headline CPI to reach 3.77% by May and 12-month core CPI to reach 2.41%. Overall, the message from March’s CPI report is that the economy is showing signs of mounting inflationary pressures beyond simple base effects. We have previously written about the ample evidence of bottlenecks in both the goods and service sectors, and we now appear to be seeing those bottlenecks show up in the price data.4 There’s little doubt that 12-month inflation will fall somewhat between May and the end of the year. However, we anticipate that inflation will still be close to the Fed’s target by the end of 2021. This will certainly be the case if the monthly inflation figures remain consistent with March’s print. The main investment implication from this view is that low inflation will not prevent the Fed from tapering its asset purchases either late this year or early next year, and it also won’t prevent the Fed from lifting rates in 2022. Footnotes 1 Greenspan’s remarks: https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 Please see US Bond Strategy Weekly Report, “Overshoot Territory”, dated April 13, 2021, available at usbs.bcaresearch.com 3 For more details on the Bond Map please see page 16 of US Bond Strategy Portfolio Allocation Summary, “It’s A Boom!”, dated April 6, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart of the WeekThe Bond Bear Mantle Being Passed To Canada? US Treasuries: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remains bond bearish and the Fed is likely to begin preparing the market later this year for a tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk of the Bank of Canada shifting to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying – perhaps even before the Fed does the same (Chart of the Week). Downgrade Canadian government bonds to underweight in global fixed income portfolios. US Treasuries: The Pause That Refreshes Chart 2UST Yield Uptrend Has Paused After leading the global government bond market selloff over the past several months, US Treasury yields have calmed down of late. The 10-year Treasury yield is down 14bps from the most recent peak of 1.74% reached March 31, while the 30-year Treasury yield is down 16bps from the peak of 2.45% reached on March 18. These moves have been concentrated in the real yield component, with inflation breakevens stable, as the 10yr and 30yr TIPS yields are down -15bps and -20bps, respectively, since the dates of those peaks in nominal yields (Chart 2). The drift lower in US yields has occurred in the face of an explosive surge in US economic data. Retail sales rose +9.8% in March compared to February and a staggering +27.7% on a year-over-year basis. The Fed’s regional manufacturing surveys showed very robust results for April, with the New York Empire State index hitting the highest level since October 2017 and the Philadelphia Fed headline index surging to a level last seen in 1973. This follows the very strong payrolls and ISM data for March that came out in early April. Yet the US economic data is not unanimously positive. The latest readings from the University of Michigan consumer confidence and NFIB small business optimism surveys both remained well below pre-pandemic peaks (Chart 3). Annual core CPI inflation only inched up 0.2 percentage points in March to 1.6%, a tepid move compared to the base effect driven surge that took year-over-year headline CPI inflation from 1.7% in February to 2.6%. Chart 3Some Mixed Messages From Recent US Data Chart 4Fewer Positive US Data Surprises The overall flow of US economic data has been disappointing versus elevated expectations, as evidenced by the almost uninterrupted decline in the Citigroup US data surprise index since peaking in July of 2020 (Chart 4). This indicator reliably correlated to the momentum of US Treasury yields prior to the COVID-19 outbreak and now, given the bullish growth combination of vaccine optimism and fiscal stimulus, the bond market’s focus is returning to how US data evolves versus expectations - and what that means for the Fed’s future moves on monetary policy. The most senior leadership at the Fed continues to send a consistent message on policy, with no rate hikes expected before 2024 and no hints at when the tapering of quantitative easing (QE) could begin. Yet some Fed officials have started to be a bit more vocal about their comfort level with the current accommodative policy stance and the associated risks to financial stability and inflation. Last week, Dallas Fed President Robert Kaplan noted that he would like to see the Fed begin to withdraw its support for the economy “at the earliest opportunity”. St. Louis Fed President James Bullard was even more specific, noting that once the share of vaccinated Americans reaches “herd immunity” levels of 75-80%, it will be time for the Fed to debate tapering QE. At the moment, however, there is no need for the Fed to move preemptively. Our Fed Monitor - comprised of economic, inflation and financial market data that would signal pressure for the Fed to ease or tighten policy – is at a neutral level (Chart 5). Our 12-month Fed discounter, which measures the change in interest rates over the next year that is priced into the US overnight index swap (OIS) curve, is at 7bps, consistent with a stand-pat Fed. The latest read this month from the New York Fed’s Survey of Primary Dealers (and Survey of Market Participants) showed no change in the median longer-run expectation for the fed funds rate of 2.25% that has prevailed over the past year (middle panel) – despite a sharp recovery in US growth expectations. Chart 5UST Valuations A Bit Stretched The market pricing of the Fed’s next move is still relatively benign, with liftoff not expected until February 2023. This suggests that a pause in the trend of rising Treasury yields was essentially the market getting a bit ahead of itself in pricing in higher longer-term yields. This can be seen by looking at various valuation measures. For example, the 5-year/5-year forward Treasury yield now sits at 2.4%, which is at the high end of the range of longer-run fed funds rate expectations from the Primary Dealer survey. Also, various measures of the term premium on 10-year Treasury yields have returned to the above-zero levels last seen during the Fed’s 2016-2018 rate hiking cycle – even with the Fed not signaling any need to tighten policy in response to rising inflation expectations. Despite these signs of stretched near-term UST valuation, there is still no sign of major global bond investors being comfortable with increasing exposure to Treasuries. For example, despite yields on 10-year Treasuries (hedged into euros and yen) looking historically attractive compared to the near-zero yields on JGBs and sub-zero yields on German Bunds, the US Treasury’s capital flow data shows that foreign investors remain net sellers of Treasuries (Chart 6). It is possible that those foreign buyers need more evidence of a sustained decrease in US bond volatility before moving money into US Treasuries, where duration losses from higher US yields could wipe out the yield pickup from moving into US bonds. While valuations are a bit stretched for Treasuries, technicals appear very oversold. Both the deviation of the 10-year Treasury yield from its 200-day moving average, and the 6-month rate of change of the Bloomberg Barclays US Treasury total return index, are at levels seen only four previous times since 2010 (Chart 7). The JP Morgan client duration positioning surveys and the Market Vane Treasury sentiment index are also approaching post-2010 bearish extremes. It should be noted that both of those measures reached even more bearish extremes during the latter half of the Fed’s 2026-2018 tightening cycle, so there is potential for Treasury sentiment to become even more bearish once the Fed starts to tighten monetary policy – a scenario looking increasingly likely over the next 6-12 months. Chart 6No Foreign Bid For USTs (Yet) Chart 7USTs Are Technically Oversold We continue to expect a robust US economy and rising inflation to force the Fed to begin preparing the market in the latter half of 2021 for QE tapering in 2022, with the first rate hike of the next tightening cycle coming in late 2022. As that outcome appears largely consistent with current market pricing, amid oversold technicals, it is likely that Treasury yields will continue to move sideways over at least the next few weeks. Yet there is little to suggest that yields have peaked and are about to enter a new downtrend, given the accelerating pace of US vaccinations that is boosting optimism on an eventual end to the US leg of the pandemic. Stay defensive on US Treasury exposure, as the cyclical rise in yields is not over yet. Bottom Line: The steady climb of US bond yields has left longer-maturity Treasuries in an oversold position. However, underlying growth and inflation momentum remain bond bearish and the Fed is likely to begin preparing the market later this year for tapering of asset purchases in 2022. Maintain a medium-term defensive posture towards US Treasuries (below-benchmark duration and an underweight country allocation). Canada: Downgrade To Underweight In a Special Report published back in February along with our colleagues at BCA Foreign Exchange Strategy, we outlined the case for placing Canadian government debt on “downgrade watch” in global fixed income portfolios.1 We expected Canadian bond yields to continue rising along with the rise in global bond yields and, hence, we maintained our below-benchmark recommended duration exposure within Canada. Chart 8Canada: A High Beta Bond Market Once Again However, we concluded that it was too soon to shift to a full-blown underweight stance on Canadian government bonds with COVID-19 cases still raging through the country, the vaccination program off to a very slow start, and the Bank of Canada (BoC)’s QE program preventing Canadian bonds from returning to their usual “high-beta” status within developed economy bond markets. It now appears that we were too cautious on that front. Canadian government bonds have been one of the worst performing markets year-to-date within the Bloomberg Barclays Global Government bond index, delivering a local currency return of –4.1% - worse than the -3.5% return earned on US Treasuries so far in 2021.2 It is clear that the Canadian government bonds are once again a market more sensitive to global interest rate moves (Chart 8). In that February Special Report, we laid out three factors that could prompt the BoC to move to a less dovish, and more bond bearish, monetary policy stance faster than we expected. Much of that list has already started to come to fruition. 1) Good News On The Vaccine Rollout Sadly, Canada is suffering a third wave of COVID-19 cases that has resulted in the nation’s most populous province, Ontario, implementing the harshest lockdown yet seen during the pandemic. Yet the pace of vaccinations has also been rising with the share of Canadians receiving at least one jab is now 21% (Chart 9) - higher than that of the overall European Union (EU). Canada is now administering more daily vaccinations than both the UK and EU. The quickening pace of vaccinations is already providing a major lift to Canadian economic confidence. The Bloomberg Nanos consumer confidence index is at an all-time high (Chart 10), while the BoC’s Business Outlook Survey for the spring of 2021 was incredibly solid. Two-thirds of firms in that survey expect sales to exceed pre-pandemic levels, even with the latest upturn in COVID-19 cases. Chart 9Canadian Vaccine Rollout Improving Chart 10Booming Optimism The BoC’s Q1/2021 Consumer Survey showed similar levels of optimism. 74% of Canadians surveyed aged 25-54 are planning to engage in levels of social and economic activities equal to, or greater than, those seen prior to the pandemic once the majority is vaccinated (Chart 11). A net majority (18%) of those surveyed plan to spend more on the types of “high-touch” service spending unavailable during the pandemic, like travel, movies and dining in restaurants, once a majority is vaccinated (Chart 12). Chart 11Canadians Are Ready To Have Fun Once Again All of the Canadian survey data is sending a clear message: a faster vaccine rollout will leader to much faster spending by consumers and businesses. 2) Signs Of Financial Stability Risks Highly-indebted Canadians' love affair with real estate has always concerned the BoC. While a combination of cutting policy interest rates to zero and ramping up QE helped stabilize Canadian financial markets during the 2020 pandemic shock, it has also set off a new surge of housing speculation. According to the Bloomberg Nanos consumer survey, 67% of Canadians now expect house prices to appreciate. The demand for homes has given a lift to the Canadian economy through a surge in new housing starts (residential investment is 8% of Canadian real GDP), while pushing national house price inflation back above 10% (Chart 13). Chart 12A Surge In "High-Touch" Spending Awaits Canadian Herd Immunity As already indebted Canadian households pile on more debt to partake in another national home-buying party, the BoC must now concern itself with the potential financial stability risks from a too-rapid rise in housing values. Chart 13Yet Another Canadian Housing Boom In a recent speech, BoC Deputy Governor Toni Gravelle noted that the BoC had to introduce QE in 2020 to help fight COVID-related dysfunction across a variety of Canadian financial markets, including government bonds where liquidity dried up.3 Gravelle also noted that the BoC would begin to dial back QE once it was clear that financial markets no longer needed the support from QE. With Canadian equities booming and Canadian corporate bond spreads near the lowest levels of the past decade (Chart 14), it seems clear that the BoC can begin dialing back its government bond purchase program if it is no longer necessary and likely fueling another housing bubble. 3) Additional Large Fiscal Stimulus The governing Canadian Liberal government of Prime Minister Justin Trudeau delivered a massive amount of fiscal stimulus to the pandemic-stricken Canadian economy in 2020. In the 2021/22 federal budget announced yesterday, another huge burst of spending was introduced, equal to C$101bn or 4.2% of Canadian GDP over the next three years. The spending was described as another COVID relief package, but included many long-term programs like national child care, raising the minimum wage and boosting green investments. According to the projections from the latest IMF World Fiscal Monitor, the “fiscal thrust” for Canada – the change in the cyclically-adjusted primary budget balance as a share of GDP - was projected to turn from a stimulus of +9% in 2020 to a drag of -2% in 2021 (Chart 15). The spending announced in the latest budget will effectively eliminate that drag for the next three years. This will provide a major lift to an economy already likely to see booming post-pandemic growth. Chart 14BoC QE No Longer Necessary Chart 15No Fiscal Drag Now Expected In 2021 Chart 16Canadian Real Yields Are Too Low Given the combination of expanding vaccinations, surging confidence, a renewed housing boom and soaring financial markets, it will be difficult for the BoC to maintain its current policy settings for much longer. This is a central bank that engaged in QE reluctantly last year and numerous BoC officials have stated – even in the worst days of the global pandemic - that they would begin to remove accommodation once it was no longer needed. Interest rate markets have already moved to price in a full-blown BoC tightening cycle. The Canadian OIS curve now discounts “liftoff” (a full 25bp rate hike) in October 2022, with 163bps of rate hikes priced in to the end of 2024 (Chart 16). The projected path of rates is below the BoC’s inflation forecasts to 2023. Thus, the implied Canadian real policy rate is expected to remain negative over the next two years – even though the BoC estimates that the neutral policy rate range is 1.75% to 2.75%, or -0.25% to +0.75% in real terms after subtracting the midpoint of the BoC’s 1-3% inflation target band. In other words, Canadian interest rate markets are vulnerable to any BoC shift in a less dovish direction, as seems increasingly likely sometime in the next few months. Our BoC Monitor is rapidly moving out of the “easier policy required” zone (Chart 17), and the rapid improvement in the Canadian employment situation suggests the BoC will be under more pressure to begin signaling a path towards withdrawing policy accommodation. This will start with an announced tapering of QE purchases, perhaps even ahead of any signals from the Fed that it is doing the same (Chart 18). This justifies a more cautious stance on Canadian fixed income exposure. Chart 17Downgrade Canadian Government Bonds To Underweight Chart 18Could The BoC Start Tapering Before The Fed? While a BoC tapering announcement before the Fed would likely put upward pressure on the Canadian dollar versus the US dollar, that would be something the BoC could live with if the economy was rapidly gaining strength – especially as our currency strategists believe the “loonie” to be undervalued. Thus, we are formally downgrading our strategic recommended allocation to Canadian government bonds to underweight (2 out of 5, see table on page 16). We are also maintaining our recommended below-benchmark duration exposure within dedicated Canadian bond portfolios. We are also cutting the allocation to Canada to underweight in our model bond portfolio and placing the proceeds in both, the US and core Europe (see pages 14-15). Bottom Line: The Canadian economy is gaining significant positive momentum, with an increased pace of vaccinations boosting optimism despite a third wave of COVID-19. We now see a growing risk that the Bank of Canada shifts to a less dovish policy stance sometime in the next few months, led by a tapering of its bond buying. Downgrade Canadian government bonds to underweight in global fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com and gfis.bcaresearch.com. 2 That Canadian return is virtually the same after hedging into US dollars, hence that local currency return can be compared to the US dollar denominated Treasury market return. 3https://www.bankofcanada.ca/2021/03/market-stress-relief-role-bank-canadas-balance-sheet Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Chart 2DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Chart 10Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights On a timeframe of a few years, a net deflationary shock is a near-certainty even if we do not know its precise nature or its precise timing. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will ultimately reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this presents a mouth-watering 100 percent return on the long-duration T-bond. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should steer towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Fractal trade shortlist: Taiwan versus China, Netherlands versus China, and Sweden versus Finland. Feature Chart I-1For Long-Term Investors, A Shock Is A Near-Certainty Predicting shocks is easy. The precise nature and timing of shocks is not predictable, but the statistical distribution of shocks is highly predictable. This means that the longer our investment timeframe, the more certain we are of encountering at least one shock – even if we cannot predict its precise nature or timing. Many economists and strategists blame their forecasting errors on shocks, such as the pandemic, which they point out are ‘unforecastable.’ Absent the shocks, they argue, their predictions of the economy and the markets would have turned out right. This is a valid excuse for short-term forecasting errors, but it is not a valid excuse for long-term forecasting errors. On a long-term horizon, encountering a major shock, or several major shocks, is a near-certainty. Hence, economists and strategists who are not incorporating the well-defined statistical distribution of shocks into their long-term investment forecasts and strategies are making a mistake. Individual Shocks Are Not Predictable In the 21 years of this century so far, there have been five shocks whose economic/financial consequences have been felt worldwide: the dot com bust (2000); the global financial crisis (2007/8); the euro debt crisis (2011/12); the emerging markets recession (2014/15); and the global pandemic (2020). To these we can add two wide-reaching political shocks: the Brexit vote (2016); and Donald Trump’s shock victory in the US presidential election (2016). In total, this constitutes seven shocks, four economic/financial, two political, and one natural (Chart I-2). Chart I-2The Seven Global Shocks Of The Century (So Far) Some people argue that economic/financial shocks are predictable, because they arise from vulnerabilities in the economy or financial markets, which should be easy to spot. Unfortunately, though such vulnerabilities are obvious in hindsight, the greatest economic minds cannot see them in real time. The greatest economic minds cannot see economic vulnerabilities. Infamously, on the eve of the global financial crisis, Ben Bernanke was insisting that “there’s not much indication that subprime mortgage issues have spread into the broader mortgage market.” Equally infamously, on the eve of the euro debt crisis, Mario Draghi was asking “what makes you think that the ECB must become lender of last resort to governments to keep the eurozone together?” (Chart I-3 and Chart I-4) Chart I-3Bernanke Couldn't See The GFC Chart I-4Draghi Couldn't See The Euro Debt Crisis Which begs the question, what is the current vulnerability that today’s great economic minds cannot see? As we have documented many times, most recently in The Rational Bubble Is Turning Irrational, the current vulnerability is the exponential relationship between rising bond yields and the risk premiums on equities and other risk-assets (Chart I-5 and Chart I-6). Meaning that $500 trillion of risk-assets are vulnerable to any substantial further rise in bond yields. Chart I-5A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 Percent... Chart I-6...Than When The Bond Yield Started ##br##At 3 Percent The second type of shock – political shocks – should be predictable as they mostly arise from well-defined events such as elections and referenda, which an army of political experts analyses ad nauseam. Yet the greatest political minds could not see Brexit or President Trump coming. Indeed, even ‘Team Brexit’ didn’t see Brexit coming, because it had no plan on how to implement Brexit once the vote was won. The third type of shocks – natural shocks – are clearly unpredictable as individual events. Nobody knows when the next major pandemic, earthquake, volcano eruption, tsunami, solar flare, or asteroid strike is going happen. Yet, to repeat, while the precise nature and timing of shocks is not predictable, the statistical distribution of shocks is highly predictable. The Statistical Distribution Of Shocks Is Highly Predictable The good news is that shocks follow well-defined statistical ‘power laws’ which allow us to accurately forecast how many shocks to expect in any long timeframe. The 7 shocks experienced through the past 21 years equates to a shock every three years on average, or 3.33 shocks in any 10-year period. The expected wait to the next shock is three years. The next few paragraphs delve into some necessary mathematics, but don’t worry, you don’t need to understand the maths to appreciate the key takeaways. If the past 21 years is representative, we propose that the number of shocks in any 10-year period follows a so-called Poisson distribution with parameter 3.33. From this distribution, it follows that the probability of going through a 5-year period without a shock is just 19 percent, and the probability of going through a 10-year period without a shock is a negligible 4 percent (Chart of the Week). The result is that if you are a long-term investor, then encountering a shock is a near-certainty and should be built into your investment strategy. How can we test our assumption that the number of shocks follows a Poisson distribution? The maths tells us that if the number of shocks follows a Poisson distribution with parameter 3.33, then the ‘waiting time’ between shocks follows a so-called Exponential distribution also with parameter 3.33. On this basis, 63 percent of the waits between shocks should be up to three years, 23 percent should be four to six years, and 14 percent should be over six years. Now we can compare this expected distribution with the actual distribution of waits between the 7 shocks encountered so far in this century. We find that the theory lines up closely with the practice, validating our assumption of a Poisson distribution (Chart I-7 and Chart I-8). Chart I-7The Theoretical Waiting Time Between Shocks… Chart II-8…Is Close To The Actual Waiting Time Between Shocks To repeat the key takeaways, on a long-term timeframe, encountering at least one shock is a near-certainty, and the expected wait to the next shock is three years. A Shock Is A Near-Certainty, And It Will End Up Deflationary Nevertheless, there remains a pressing question: Will the next shock(s) be deflationary or reflationary? It turns out that all shocks end up with both deflationary and reflationary components: either a deflationary impulse followed by a reflationary backlash or, as we highlighted in The Road To Inflation Ends At Deflation, a reflationary impulse followed by a deflationary backlash. But the crucial point is that the deflationary component will swamp the reflationary component. In the seven shocks of this century so far, six have been deflationary impulses with a weaker reflationary backlash; and one – the reflation trade of 2017-18 – was a reflationary impulse with a stronger deflationary backlash. It is our high conviction view that in the next shock(s), the deflationary component will continue to hold the upper hand (Chart I-9). Chart I-9Each Shock Has A Deflationary And Reflationary Component... But The Deflationary Component Tends To Dominate The simple reason is that as financial asset prices, real estate prices, and debt servicing costs get addicted to ever lower bond yields, the economy and financial markets cannot tolerate bond yields reaching previous tightening highs and, just like all addicts, need a new extreme loosening to feel any stimulus. This means that when the next shock comes – as it surely will – it will require lower lows and lower highs in the bond yield cycle. Let’s sum up. On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise nature – economic/financial, political, or natural – or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will eventually reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this constitutes a mouth-watering 100 percent return on the long-duration T-bond. The 10-year T-bond yield will eventually reach zero. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should tilt towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Candidates For Countertrend Reversals This week we have noticed an unusual decoupling among the tech-heavy markets of Taiwan, Netherlands, and China (Chart I-10). Chart I-10An Unusual Decoupling Between Tech-Heavy Netherlands And China Among these three markets, the strong short-term outperformance of both Taiwan and Netherlands are due to supply bottlenecks in the semiconductor sector that have boosted Taiwan Semiconductor Manufacturing and ASML, but we expect these bottlenecks ultimately to resolve.  On this basis and combined with extremely fragile 130-day fractal structures, Taiwan versus China and Netherlands versus China are vulnerable to reversals (Chart I-11 and Chart I-12). Chart I-11Underweight Taiwan Versus China Chart I-12Underweight Netherlands Versus China Our first recommended trade is to underweight Netherlands versus China, setting a profit target and symmetrical stop-loss at 5 percent. Another outperformance that looks fragile on its 130-day fractal structure is Sweden versus Finland, driven by industrials and financials versus energy and materials (Chart I-13). Chart I-13Underweight Sweden Versus Finland Our second recommended trade is to underweight Sweden versus Finland, setting a profit target and symmetrical stop-loss at 4.7 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations