Emerging Markets

Highlights Over the short term – 1-2 years – the pick-up in re-infection rates in Asia and LatAm states with large-scale deployments of Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery (Chart of the Week). The UAE-Saudi impasse re extending the return of additional volumes of OPEC 2.0 spare capacity to the oil market over 2H21 will be short-lived.  The UAE's official baseline production will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly.  Over the medium term – 3-5 years out – the risk to the expansion of metal supplies needed for renewables and electric vehicles (EVs) will rise, as left-of-center governments increase taxes and royalties, and carbon prices move higher. Rising metals costs will redound to the benefit of oil and gas producers, and accelerate R+D in carbon- and GHG-reduction technologies. Longer-term – 5-10 years out – the active discouragement of investment in hydrocarbons will contribute to energy shortages. In anticipation of continued upside volatility in commodity prices and share values of oil, gas and metals producers, we remain long the S&P GSCI and COMT ETF, and long equities of producers and traders via the PICK ETF. Feature Our conversations with clients almost invariably leads us to considering the risks to our long-standing bullish views for energy and metals. This week, we reprise some of the highlights of these conversations. In the short term, our bullish call on oil is underpinned by the assumption of continued expansion in vaccinations, which we believe will lead to global economic re-opening and increased mobility, as the world emerges from the devastation of COVID-19. This expectation is once again under scrutiny. On the supply side, the very public negotiations undertaken by the UAE and the leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and Russia – over re-basing the UAE's production reminds investors there is substantial spare capacity from the coalition available for the market over the short term. The slow news cycle going into the US Independence Day holiday certainly was a fortuitous time to make such a point. Chart of the WeekWorrisome Uptick Of COVID-19 Cases Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views KSA-UAE Supply-Side Worries The abrupt end to this week's OPEC 2.0 meeting was unsettling to markets. Shortly after the meeting ended – without being concluded – officials from the Biden administration in the US spoke with officials from KSA and the UAE, presumably to encourage resolution of outstanding issues and to get more oil into the market to keep crude oil prices below $80/bbl (Chart 2). We're confident the KSA-UAE impasse re extending the return of additional volumes of spare capacity to the oil market over 2H21 will be short-lived. The UAE's official baseline production number (i.e., its October 2018 output level) will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly. Coupled with a likely return of Iranian export volumes in 4Q21, this will bring prices down into the mid- to high-$60/bbl range we are forecasting. Chart 2US Pushing For Resolution of KSA-UAE Spat US Pushing For Resolution of KSA-UAE Spat US Pushing For Resolution of KSA-UAE Spat Longer term, markets are worried this incident is a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy, which has lifted oil prices 200% since their March 2020 nadir. At present, the producer coalition has ~ 6-7mm b/d of spare capacity, which resulted from its strategy to keep the level of supply below demand. A breakdown in this discipline – in extremis, another price war of the sort seen in March 2020 or from 2014-2016 – could plunge oil markets into a price collapse that re-visits sub-$40/bbl levels. In our view, economics – specifically the cold economic reality of the price elasticity of supply – continues to work for the OPEC 2.0 coalition: Higher revenues are realized by members of the group as long as relatively small production cuts produce larger revenue gains – e.g., a 5% (or less) cut in production that produces a 20% (or more) increase in price trumps a 20% increase in production that reduces prices by 50%. Besides, none of the members of the coalition possess the wherewithal to endure another shock-and-awe display from KSA similar to the one following the breakdown of the March 2020 OPEC 2.0 meeting. We also continue to expect US shale-oil producers to be disciplined by capital markets, and to retain a focus on providing competitive returns to their shareholders, which will limit supply growth to that which maintains profitability. Until we see actual evidence of a breakdown in the coalition's willingness to maintain its production-management strategy, we will continue to assume it remains operative. Worrisome COVID-19 Re-Infection Trends Reports of increased re-infection rates in Latin American and Asia-Pacific states providing Chinese Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery. Conclusive data on the efficacy of these vaccines is not available at present, based on reporting from Health Policy Watch (HPW).1 The vast majority of these vaccines were purchased in Latin America and the Asia-Pacific region, where ~ 80% of the 759mm doses of the two Chinese vaccines were sold, according to HPW's reporting. This will draw the attention of markets to this risk (Chart 3). Of particular concern are the increases in re-infection rates in the Seychelles and Chile, where the majority of populations in both countries were inoculated with one of the Chinese vaccines. Re-infections in Indonesia also are drawing attention, where more than 350 healthcare workers were re-infected after receiving the Sinovac vaccination.2 The risk of renewed global lockdowns remains small, but if these experiences are repeated globally with adverse health consequences, this assessment could be challenged. Chart 3COVID-19 Returning In High-Vaccination States Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Transition Risks To A Low-Carbon Economy Over the medium- to long-terms, our metals views are premised on the expectation the build-out of the global EV fleet and renewable electricity generation – including its supporting grids – will require massive increases in the supply of copper, aluminum, nickel, and tin, not to mention iron ore and steel. This surge in demand will be occurring as governments rush headlong into unplanned and unsynchronized wind-downs of investment in the hydrocarbon fuels that power modern economies.3 The big risk here is new metal supplies will not be delivered fast enough to build all of the renewable generation, EVs and their supporting grids and infrastructures to cover the loss of hydrocarbons phased out by policy, legal and boardroom challenges. Such a turn of events would re-invigorate oil and gas production. Renewable energy and electric vehicles are the sine qua non of the drive to achieve net-zero carbon emissions by 2050. However, the rising price of base metals will add to already high costs of rebuilding power grids to make them suitable for green energy. Given miners’ reluctance to invest in new mines, we do not expect metals prices to drop anytime soon. According to Wood Mackenzie, in 2019 the cost of shifting just the US power grid to renewable energy over the next 10 years will amount to $4.5 trillion.4 Given these cost and supply barriers, fossil fuels will need to be used for longer than the IEA outlined in its recent and controversial report on transitioning to a net-zero economy.5 To ensure that fossil fuels can be used while countries work to achieve their net zero goals, carbon capture utilization and storage (CCUS) technology will need to be developed and made cheaper. The main barrier to entry for CCUS technology is its high cost (Chart 4). However, like renewable energy, the more it is deployed and invested in, the cheaper it will become, following the trend seen in the development of renewable energy and EVs, which were aided by large-scale subsidies from governments to encourage the development of the technology. These cost reductions are already visible: In its 2019 report, the Global CCS Institute noted the cost of implementing CCS technology initially used in 2014 had fallen by 35% three years later. Chart 4CCUS Can Be Expensive Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Metals Mines' Long Lead Times In 2020 the total amount of discovered copper reserves in the world stood at ~ 870mm MT (Chart 5), according to the US Geological Service (USGS). As of 2017, the total identified and undiscovered amount of reserves was ~ 5.6 billion MT.6 The World Bank recently estimated additional demand for copper would amount to ~ 20mm MT p.a. by 2050 (Chart 6).7 Glencore’s recently retired CEO Ivan Glasenberg last month said that by 2050, miners will need to produce around 60mm MT p.a. of copper to keep up with demand for countries’ net zero initiatives.8 Even with this higher estimate, if miners focus on exploration and can tap into undiscovered reserves, supply will cover demand for the renewable energy buildout. Chart 5Copper Reserves Are Abundant Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Chart 6Call On Base Metals Supply Will Be Massive Out To 2050 Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views While recent legislative developments in Chile and Peru, which together constitute ~ 34% of total discovered copper reserves, could lead to significantly higher costs as left-of-center governments re-write these states' constitutions, geological factors would not be the main constraint to copper supply for the renewables energy buildout: Even if copper mining companies were to move out of these two countries, there still is about 570 million MT in discovered copper reserves, and nearly ten times that amount in undiscovered reserves. As we have written in the past, capital expenditure restraint is the principal reason the supply side of copper markets – and base metals generally – is challenged (Chart 7). Unlike in the previous commodity boom, this time mining companies are focusing on providing returns to shareholders, instead of funding the development of new mines (Chart 8). Chart 7Copper Prices Remains Parsimonious Copper Prices Remains Parsimonious Copper Prices Remains Parsimonious Chart 8Shareholder Interests Predominate Metals Agendas Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Of course, it is likely metals miners, like oil producers, are waiting to see actual demand for copper and other base metals pick up before ramping capex. Sharp increases in forecasted demand is not compelling for miners, at this point. This means metals prices could stay elevated for an extended period, given the 10-15-year lead times for copper mines (Chart 9). For example, the Kamoa-Kakula mine in the Democratic Republic of Congo (DRC) now being brought on line took roughly 24 years of exploration and development work, before it started producing copper. Technological breakthroughs that increase brownfield projects’ productivity, or significant increases in the amount of recycled copper as a percent of total copper supply would address some of the price pressures arising from the long lead times associated with the development of new copper supply. Another scenario with a non-trivial probability that threatens the viability of metals investing is a breakthrough – or breakthroughs – in CCUS technology, which allows oil and gas producers to remove enough carbon from their fuels to allow firms using these fuels to achieve their net-zero carbon goals. Chart 9Long Lead Times For Mine Development Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Investment Implications Short-term supply-demand issues affecting the oil market at present are transitory, and do not signal a shift in the fundamentals supporting our bullish call on oil. Our thesis based on continued production discipline remains intact. That said, we will continue to subject it to rigorous scrutiny on a continual basis. Our average Brent forecast for 2021 remains $66.50/bbl, with 2H21 prices averaging $70/bbl. For 2022 and 2023 we continue to expect prices to average $74 and $81/bbl, respectively (Chart 10). WTI will trade $2-$3/bbl lower. Our metals view has become slightly more nuanced, thanks to our client conversations. One of the unintended consequences of the unplanned and uncoordinated rush to a net-zero carbon future will be an improvement in the competitive position of oil and gas as transportation fuels and electric-generation fuels going forward. This will be driven by rising costs of developing and delivering the metals supplies needed to effect the net-zero transition. We expect markets will provide incentives to CCUS technologies and efforts to decarbonize oil and gas fuels, which will contribute to the global effort to arrest rising temperatures. This suggests the rush to sell these assets – which is underway at present – could be premature.9 In the extreme, this could be a true counterbalance to the metals story, if it plays out. Chart 10Our Oil Price View Remains Intact Our Oil Price View Remains Intact Our Oil Price View Remains Intact     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 The monthly OPEC 2.0 meeting ended without any action to increase monthly supplies, following the UAE's bid to increase its baseline reference production – determined based on October 2018 production levels – to 3.8mm b/d, up from 3.2mm b/d. S&P Global Platts reported the UAE's Energy Minister, Suhail al-Mazrouei, advanced a proposal to raise its monthly production level under the coalition's overall output deal, while KSA's energy minister, Prince Abdulaziz bin Salman, insisted the UAE follow OPEC 2.0 procedures in seeking an output increase. We do not expect this issue to become a protracted standoff between these states. The disagreement between the ministers is procedural to substantive. Remarks by bin Salman last month – to wit, KSA has a role in containing inflation globally – and his earlier assertions that production policy of OPEC 2.0 would be driven by actual oil demand, as opposed to forecasted oil demand, suggest the Kingdom is not aiming for higher oil prices per se. Base Metals: Bullish Spot benchmark iron ore (62 Fe) prices traded above $222/MT this week in China on the back of stronger steel demand, according to mining.com (Chart 11). Market participants are anticipating further steel-production restrictions and appear to be trying to get out in front of them. Precious Metals: Bullish The USD rally eased this week, allowing gold prices to stabilize following the June Federal Open Market Committee (FOMC) meeting. In the two weeks since the FOMC, our gold composite indicator shows that gold started entering oversold territory (Chart 12). We believe gold prices will start correcting upwards, expecting investor bargain-hunting to pick up after the price drop. The mixed US jobs report, which showed the unemployment rate ticked up more than expected, implies that interest rates are not going to be raised soon. Our colleagues at BCA Research's US Bond Strategy (USBS) expect rates to increase only by end-2022.10 This, along with slightly higher odds of a potential COVID-19 resurgence, will support gold prices in the near-term. Ags/Softs: Neutral The USDA's Crop Progress report for the week ended 4 July 2021 showed 64% of the US corn crop was in good to excellent condition, down from the 71% reported for the comparable 2020 date. The Department reported 59% of the bean crop was in good to excellent shape vs 71% the year earlier. Chart 11 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN Chart 12 Sentiment Supports Oil Prices Sentiment Supports Oil Prices     Footnotes 1     Please see Are Chinese COVID Vaccines Underperforming? A Dearth of Real-Life Studies Leaves Unanswered Questions, published by Health Policy Watch, June 18, 2021. 2     According to HPW, the World Health Organization's Emergency Use Listing for these two vaccines "were unique in that unlike the Pfizer, AstraZeneca, Moderna, and Jonhson & Johonson vaccines that it had also approved, neither had undergone review and approval by a strict national or regional regulatory authority such as the US Food and Drug Administration or the European Medicines Agency. Nor have Phase 3 results of the Sinopharm and Sinovac trials been published in a peer-reviewed medical journal.  More to the point, post-approval, any large-scale tracking of the efficacy of the Sinovac and Sinopharm vaccine rollouts by WHO or national authorities seems to be missing." 3    Please see A Perfect Energy Storm On The Way, which we published on June 3, 2021 for additional discussion.  It is available at ces.bcaresearch.com. 4    Please refer to The Price of a Fully Renewable US Grid: $4.5 Trillion, published by greentechmedia 28 June 2019. 5    Please refer to the IEA's Net Zero By 2050, published in May 2021. 6    Please refer to USGS Mineral Commodity Summaries, 2021. 7     Please refer to Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition, published by the World Bank. 8    Please refer to Copper supply needs to double by 2050, Glencore CEO says, published by reuters.com on June 22, 2021. 9    Please see the FT's excellent coverage of this trend in A $140bn asset sale: the investors cashing in on Big Oil’s push to net zero published on July 6, 2021. 10   Please refer to Watch Employment, Not Inflation, published by the USBS on June 15, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Please note: There will be no Strategy Report next week, July 15. Our next publication will be a Thematic: Charts That Matter, on July 22. Highlights For any country with local currency public debt, the ultimate constraints to lower debt burden and service debt are the magnitude of inflation overshoot and/or currency depreciation that authorities are willing to tolerate. What makes Brazil’s public debt untenable is not the level of debt but the very high domestic interest rates. Growing odds of Lula’s victory in the next presidential election in October 2022 entail an eventual shift to more pro-growth fiscal and monetary policies in Brazil. The upshot of these policies will be higher inflation and chronic currency depreciation. Brazilian share prices will likely rally on the back of high nominal growth over the coming years. Yet, currency depreciation will dampen equity returns for international investors. Absolute-return investors with a medium- and long-term horizon should consider going long stocks and shorting the BRL. Feature One of the structural challenges Brazil faces is the public debt overhang. Fiscal and monetary authorities have responded by periodically embarking on fiscal and monetary austerity. Yet, such austerity depresses nominal growth and has in fact worsened public debt dynamics. Can Brazil break out of the vicious circle that has held the economy in check for the past several years? We suspect that authorities will ultimately move away from fiscal and monetary tightening despite the large public debt overhang. Abandoning fiscal and monetary austerity will boost growth. However, these policies will entail higher inflation and currency depreciation. Such a macro shift warrants the following long-term investment strategy in Brazil: going long stocks and shorting the real. Policymakers’ Ultimate Constraint For any country with local currency public debt, the ultimate constraints to lower debt burden and service debt are the magnitude of inflation overshoot and/or currency depreciation that authorities are willing to tolerate. In Brazil, such a policy trade-off is pertinent because productivity-boosting structural reforms – that could lift its potential GDP growth rate – are not realistic in the foreseeable future. We discuss the political landscape and economic policies in detail below. Chart 1Sufficient Fiscal Tightening To Stabilize Public Debt Is Not Politically Feasible Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? As we have written previously, any country with predominantly local currency public debt can stabilize the debt-to-GDP ratio by either (1) running continuous sizable primary surpluses or (2) having nominal GDP growth consistently above the interest rate on government debt. The former is politically unfeasible in Brazil because it requires such substantial fiscal tightening that no government can deliver (Chart 1). The second criteria of having nominal GDP to grow meaningfully above government borrowing costs cannot be achieved in Brazil without major government stimulus to boost nominal GDP while also capping local bond yields. Although the nation’s nominal GDP growth has recently improved at about 6.5-7%, its underlying trend is still below government borrowing costs in local currency at 8% (Chart 2). Chart 2Brazil Needs Higher Nominal GDP Growth And Lower Domestic Bond Yields Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? If and as the central bank (BCB) continues to hike policy rate, government effective borrowing costs will rise. The basis is that in recent years, the government has drastically increased the share of short-term local currency debt. Consequently, as the BCB raises the SELIC rate and as the government has to roll over maturing short-term bonds, its borrowing costs will rise. Chart 3Various Measures Of Public Debt Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? On the whole, we consider that in the medium and long run, Brazil’s nominal GDP growth will need to hover at higher levels (say, 9-10%) for it to meaningfully exceed government borrowing costs of 8%. This is the only politically feasible option to achieve public debt sustainability in Brazil. Yet, this entails persistent inflation of 7-8%. Provided that Brazil’s labor force growth will be 0.5% in the coming years, and if we assume underlying productivity growth of 1.5%, the potential (real) GDP growth is probably around 2%. Hence, to achieve nominal GDP growth of 9-10%, inflation should average 7-8%. This is only possible if fiscal and monetary policies become very stimulative. Why does Brazil need to stabilize the public debt-to-GDP ratio? The reason is that the latter is at levels where debt servicing consumes 4% of GDP or 26% of federal government spending. A higher debt-to-GDP ratio will devour more resources. With fiscal spending straightjacketed by the Fiscal Responsibility Law, rising debt servicing will curb non-interest government spending and, thus, economic growth. There are different measures of the nation’s public debt. The Brazilian central bank’s measure stands at 87% of GDP while the IMF’s measure stands at 97% of GDP. The difference is that the IMF includes all government securities held by the central bank while the BCB excludes non-repo government securities held by the BCB from its public debt calculation (please see Chart 3 and Box 1 for more information and analysis). BOX 1 What Is The Correct Measure Of Brazil’s Public Debt? The key difference between the IMF and BCB calculations of Brazil’s public debt is the way these account for government securities held by the central bank. The BCB’s measure of public debt includes its holdings of government securities used in repo operations – they amount to 15% of GDP – but excludes the ones for non-repo operations – equivalent to 10% of GDP. The IMF measure includes all government securities held by the central bank (Chart 3). Each of these two measures has its pros and cons. We will not get into technical details as to which one is superior because from a big picture perspective the precise level of public debt and how to measure it are not significant. We have three considerations concerning this point: The reason why Brazil needs to reduce the public debt-to-GDP ratio is that interest payments on public debt consume 4% of GDP or 26% of federal government spending. This is hurting Brazil’s development. The government needs to divert spending to other programs to lift the nation’s growth trajectory. “High public debt” is a relative concept and this metric should be compared with the identical measures of other countries. Given the Brazilian central bank’s large holdings of government bonds, it makes sense to compare Brazil with the US and Japan where their respective central banks also own large shares of government bonds and notes. As Chart 3 reveals, if one were to exclude the central bank’s holdings of government securities from public debt, the public debt-to-GDP ratio would be 70% in Brazil, 105% in the US and 125% in Japan. Finally, if investor concern is public debt monetization by the central bank and commercial banks, the focal point of analysis should be the level of and trend in broad money supply not the level of public debt. Chart 4 suggests that broad money supply as a share of GDP in Brazil is somewhat elevated but not very high compared with other nations. Bottom Line: What makes Brazil’s public debt untenable is not the level of debt but the very high domestic interest rates. Brazil needs much lower interest rates – potentially via financial repression – to ensure public debt sustainability. In turn, financial repression/suppression of interest rates will cause considerable currency deprecation. Chart 4Broad Money Supply-to-GDP Ratios: A Cross Country Perspective Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Yet, whether the level of public debt is 87% of GDP or 97% does not really matter. If neither of the above two criteria of public debt sustainability is satisfied, the government debt-to-GDP ratio will continue rising with negative ramifications for growth in Brazil. Chart 5Brazil: Broad Money (M4) Growth And Impulse Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? While Brazil needs higher nominal growth, local bond yields must also be capped well below nominal GDP growth. If local and foreign creditors are reluctant to finance the government at yields lower than nominal GDP growth, the central bank and/or commercial banks could fill in the gap and purchase domestic bonds. In doing so, the central bank and commercial banks would create more deposits/money supply and, thereby, ceteris paribus exert downward pressure on the exchange rate. As we have argued in previous reports, in any country, when the central bank and commercial banks purchase securities from non-banks, they create money/deposits “out of thin air.” Hence, national savings are not a constraint for the central bank and for commercial banks to finance the government and bring down government bond yields. The primary indicator to monitor whether Brazil is beginning to run more stimulative policies is the M4, the broadest measure of money supply in Brazil. It reflects the monetary and fiscal policy stance as well as captures debt monetization. Chart 5 illustrates Brazil’s M4 annual growth rate (the top panel) and its impulse – calculated as the second derivative (the bottom panel). The M4 impulse reflects how stimulative both monetary and fiscal policies are at any point in time. The spike in the M4 impulse last year reflected large fiscal stimulus and aggressive monetary easing by the central bank. Chart 6Brazil Is Going Through Large Fiscal Tightening Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? For now, the M4 impulse will continue falling because monetary policy is tightening and the fiscal thrust is estimated by the IMF to be -5% of GDP this year and -1% in 2022 (Chart 6). Bottom Line: The only chance for Brazil to stabilize public debt dynamics is to run loose monetary and fiscal policies. In short, Brazil needs to inflate its way out of public debt. The outcome will be currency depreciation yet strong nominal growth that will produce higher share prices in local currency terms. Former president Lula’s PT (Workers’ Party) and its economic policies put Brazil’s government finances on an unsustainable trajectory ten years ago. Ironically, it could be Lula’s comeback as president that could address the issue of public debt and stabilize public finances. Lula’s Comeback Chart 7Lula Is Massively Beating Bolsonaro In Polls Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Odds of former president Luiz Inácio Lula da Silva running and winning the presidential elections next year have greatly increased in recent months. His presidency will have considerable ramifications for macro-economic policies, the economy and financial markets in the medium-to-long term. The rulings of the Supreme Federal Court have legally paved the way for Lula to participate in the 2022 October presidential elections. While there are still charges pending against Lula, the odds of a full trial and conviction against the ex-president within the next 15 months are negligible. According to the latest June polls from local company IPEC, voting intentions for the first round of elections show Lula mustering over twice as many votes as Bolsonaro, and miles away from the crowded centrist camp (Chart 7). President Bolsonaro’s disapproval rating has reached an all-time high since the beginning of his term. The government’s failure to handle the COVID-19 pandemic effectively has been put in the spotlight due to an ongoing inquiry by Congress, which is being broadcast daily on public television. Further, last week the Supreme Court authorized a criminal investigation into the government for allegations of corruption and irregularities in the procurement of vaccines from India’s Covaxin. It is uncertain as to whether these trials will lead to impeachment procedures given House leader Arthur Lira’s support for Bolsonaro. Nevertheless, odds are that the investigation will cement popular opinion against the current president. There is growing evidence that Lula is positioning himself as a mainstream moderate candidate. This will give him an advantage against Bolsonaro as centrist voters will likely abandon Bolsonaro and support Lula in the upcoming presidential elections. Lula has been meeting with political leaders from the center left and center right, trying to garner support from various corners of the political spectrum that have become disillusioned with Bolsonaro. It seems Lula is attempting to position next year’s presidential elections as a matter of Bolsonaro versus the rest of the country. Most notably, Lula has secured the support of longtime rival, ex-President Fernando Cardoso. This is particularly noteworthy for two reasons: First, Cardoso represents the ultimate economic orthodoxy and pragmatism in Brazil. Second, Cardoso expressed his support for his former political arch-rival Lula in the nation’s most important economic newspaper, Valor Economico. Another important source of support for Lula will likely be the business community. The corporate establishment dropped their backing of Bolsonaro over his mishandling of the pandemic. Further, his failure to combat corruption and his inflammatory rhetoric against democratic institutions have disturbed businesspeople and investors. Anecdotal evidence shows that behind closed doors the business elite is discussing supporting Lula for several reasons. First, banks and large conglomerates had positive relations with the ex-President during the 2000s. Second, even though Lula will not pass structural economic reforms or support privatization, his behavior is at least predictable. Chart 8Brazil: Real Income Per Capita Has Plunged Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Although Lula is the most prominent member of the Workers’ Party (PT), not all voters necessarily associate him with the corruption that prevailed during the PT’s rule. Not only low-income but also middle-income households associate Lula’s presidency with rising per capita income. Neither Michel Temer’s centrist government nor Jair Bolsonaro’s right and conservative government were able to deliver rising income per capita (Chart 8). In short, centrist voters might favor Lula over Bolsonaro’s disarray. Economic Policy During Lula’s Potential Presidency Lula will not likely run on a purely socialist platform. By vying to gather support from centrist political parties and centrist voters, it is very likely that Lula’s election platform and third term will be marked by pragmatism rather than ideology. We believe fiscal policy during Lula’s presidency will be expansionary. Known as a ferocious political dealmaker, Lula will probably succeed in persuading Congress to dismantle the fiscal spending cap that limits government expenditure growth to last year’s consumer price inflation. This will allow the government to stimulate the economy via fiscal policy. Chart 9Brazil: The Economy Is Recovering But Not Surging Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Regarding monetary policy, Lula will likely build a consensus across the political spectrum for an accommodative monetary policy. The latter is required to both boost growth and to cap government borrowing costs. A shrewd political operator, Lula will likely convince Congress to change the central bank’s singular mandate of targeting inflation to include targeting economic growth and employment. The US Federal Reserve’s dual mandate might be used as a justification for the change. Bottom Line: The Brazilian population is shattered by extremely poor economic conditions and will favor the presidential candidate who promises more stimulative macro policies. Lula will appeal to such popular sentiment. Following an election win, he will work with various political parties to promote legislation enabling easier fiscal and monetary policies. In short, Lula’s policies will boost nominal GDP growth while capping government borrowing costs. This is needed to stabilize the nation’s public debt-to-GDP ratio. However, the collateral damage of these policies will be the exchange rate: the currency will depreciate meaningfully in such a scenario. A Word About Business Cycle Incoming economic data suggest the economy is recovering. However, year-on-year growth rates appear very strong partially due to a low base effect from the lockdowns a year ago. In Chart 9, we show two-year growth rates, that are annualized, for key business cycle variables. The message is that the recovery is progressing but muted. Further, the BCB has justified its rate hikes by fast rising core and headline inflation. Nevertheless, high inflation readings are also partially the result of very low prints last year from the economic lockdowns. Chart 10 removes the base effect showing a 24-month rate of change and it reveals that core measures of inflation actually remain tame. In addition, lending rates in real terms remain high. This entails that the monetary authorities are risking over-tightening and impeding the recovery. Interestingly, our marginal propensity to spend proxy is forecasting a relapse in economic growth (Chart 11). Chart 10Brazil: Core Inflation Is At The Low End Of BCB's Target Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Chart 11Is Brazil's Business Cycle About To Peak? Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Chart 12Households' Debt Servicing And Importance Of Fiscal Spending Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Importantly, the household debt-service ratio is very high, which means successive rate hikes could dampen consumption (Chart 12, top panel). In fact, there has been little improvement in the unemployment rate and household nominal disposable income and wages. Finally, the fiscal thrust is estimated by the IMF to be -5% of GDP this year and -1% in 2022 (please refer to Chart 6 above). Given government spending (excluding interest payments) accounts for 24% of GDP (Chart 12, bottom panel), fiscal tightening is a major risk to the economy over the next 18 months. Bottom Line: A combination of tightening fiscal and monetary policies will cap the economic recovery. By failing to deliver strong growth this year and next year, the government risks handing the election to ex-President Lula da Silva. While Bolsonaro will likely push to relax fiscal policy leading up to the election, our hunch is that it will be too little too late to help facilitate his reelection. Investment Conclusions Growing odds of Lula’s victory in the next presidential election in October 2022 entail a shift to more pro-growth fiscal and monetary policies in Brazil. The upshot of these policies will be higher inflation (say, core CPI above 6%) and chronic currency depreciation. Chart 13Brazilian Stock Prices, Valuations And EPS Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Brazilian share prices will likely rally on the back of high nominal growth over the coming years. Yet, currency depreciation will dampen equity returns for international investors. Absolute-return investors with a medium- and long-term horizon should consider going long stocks and shorting the BRL. Our favored segment of the equity market is Brazilian small cap stocks and exporters. The former will benefit from high nominal growth while the latter from a cheapened exchange rate. For EM portfolio managers, our recommended strategy is as follows: While still underweighting Brazil within an EM equity portfolio, we are putting this bourse on an upgrade watch list. We intend to use the potential underperformance by Brazilian stocks in the coming months to upgrade this stock market. This equity market’s valuation is close to its fair value according to our cyclically-adjusted P/E ratio (Chart 13). Relative to the EM equity benchmark, Brazilian share prices might be forming a bottom (Chart 14). We are upgrading Brazilian sovereign credit to overweight relative to the EM sovereign credit benchmark. Brazil’s foreign currency debt stands at only 11% of GDP and the government does not have a problem servicing its foreign currency debt even if the currency depreciates. For local currency bonds, we recommend patience before upgrading. As financial markets start pricing in the fact of Lula’s presidency, the real will likely drop and domestic bond yields might rise. Finally, we continue shorting BRL as a part of our EM currency basket versus the US dollar. The real will likely have a setback in the coming months due to the US dollar’s rebound, a selloff in commodities prices driven by China’s slowdown and disappointing political news flow in Brazil. Concerning currency valuation, Chart 15 shows the real’s real effective exchange rate. The upshot is that it is not cheap. Chart 14Brazil Versus EM: Relative Share Prices Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle? Chart 15The Brazilian Real Is Not Cheap Can Brazil Break Out Of A Vicious Circle? Can Brazil Break Out Of A Vicious Circle?   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Analyst juane@bcaresearch.com Footnotes

Highlights Q2/2021 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -6bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio underperformed by -21bps, led overwhelmingly by our underweight to US Treasuries (-18bps). Spread product allocations outperformed by +15bps, primarily due to overweights on US high-yield (+11bps) and US CMBS (+3bps). Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Feature The trend in global bond yields so far in 2021 has been a tale of two quarters. The first three months of the year saw a surge in yields worldwide on the back of rapidly improving economic data, the rollout of COVID-19 vaccines and supply squeezes triggering rapid increases in inflation. During the second three months of the year, however, global yields drifted a bit lower in response to more mixed economic data, the spread of the Delta variant and slightly hawkish shifts from a few key central banks – most notably, the Fed – even with economic confidence measures remaining upbeat across the developed economies. The decline in yields has not been seen across the maturity spectrum, though. The yield-to-maturity of the Bloomberg Barclays Global and US Treasury 10+ year indices fell by -12bps and -30bps, respectively, from recent peaks. At the same time, shorter term bond yields have been relatively stable as central banks continue to signal that interest rate hikes are still well off into the future. In contrast to government bonds, credit markets have remained calm with spreads tight for developed market corporates and emerging market (EM) debt. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. The latter half of 2021 should prove to be even more challenging for bond investors, who must disentangle less consistent messages across countries on the Delta variant, vaccinations, inflation and the outlook for both monetary and fiscal policy. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2021 Model Bond Portfolio Performance: Mixed Returns Chart 1Q2/2021 Performance: Credit Gains & Duration Losses Q2/2021 Performance: Credit Gains & Duration Losses Q2/2021 Performance: Credit Gains & Duration Losses The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was +1.13%, slightly underperformed the custom benchmark index by -6bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -21bps of underperformance versus our custom benchmark index while the latter outperformed by +15bps. We have remained significantly underweight US Treasuries and positioned for a bearish steepening of the US Treasury curve since just before last year's US presidential election. That tilt was a big contributor to the excess return of the portfolio in Q1 (+63bps) that was partially given back (-18bps) in Q2 as longer maturity Treasury yields fell during the quarter. Our inflation-linked bond allocations in the US and Europe (+5bps) helped mitigate the loss on the government bond side from our below-benchmark duration stance and general curve steepening bias in most countries in the portfolio (Table 2). Table 2GFIS Model Bond Portfolio Q2/2021 Overall Return Attribution GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks The sum of excess returns during the quarter from countries that we overweighted (Germany, France, Italy, Spain, and Japan) was zero. Improving growth momentum and stronger economic confidence helped push yields higher in those countries. Therefore, those positions could not offset the losses from the underweight to US Treasuries. We did make two shifts in the country allocation within the government bond portion of the portfolio during Q2, downgrading Canada to underweight on April 20 and upgrading Australia to overweight on June 9. Neither change meaningfully contributed to the return of the portfolio. Meanwhile, our moderate overall overweight tilt on spread product versus government bonds fueled the outperformance from the credit side of the portfolio, led by US high-yield (+11bps) and US CMBS (+3bps). Overall gains from spread product were impressive in both USD-hedged total return terms (+95bps) and relative to our custom benchmark (+15bps), despite spreads entering Q2 at fairly tight levels. In the second quarter, improving economic confidence and easing credit conditions allowed spreads to narrow even further for corporate debt in the US and Europe, as well as for EM USD-denominated credit. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2021 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Chart 3GFIS Model Bond Portfolio Q2/2021 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Biggest Outperformers: Overweight US high-yield: Ba-rated (+5bps), B-rated (+4bps), and Caa-rated (+3bps) Overweight US TIPS (+4bps) Overweight US CMBS (+3bps) Overweight Euro Area high-yield (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10 years (-17bps), Underweight US Treasuries with a maturity between 7 and 10 years (-3bps) Underweight US Treasuries with a maturity between 5 and 7 years (-2bps) Underweight EM USD sovereigns (-1bps) Underweight UK GIlts with a maturity greater than 10 years (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2021 GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. In Q2, the picture on that front was mixed. We were only neutral some of the biggest outperformers like UK Gilts (+312bps in USD-hedged duration-matched total return terms) and investment grade credit in the US (+430bps) and UK (+231bps). Our relative value allocation within EM, overweight corporates (+430bps) versus sovereigns (+527bps), also underperformed during Q2. We remained overweight government debt markets in the euro area which were the worst performers during the quarter (Germany: -25bps, Spain: -59bps, Italy: -67bps, and France: -83bps). The news was better on the credit side, where our significant overweight to US high-yield (+146bps) was a big positive contributor, as were overweights to US CMBS (+137bps) and euro area high-yield (+92bps). Bottom Line: Our model bond portfolio slightly underperformed its benchmark index in the second quarter of the year by -6bps – a negative result mainly driven by our underweight allocation to the US Treasury market but with an overweight to US high-yield providing a meaningful offset. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by swings in global government bond yields, most notably US Treasuries. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). Our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, remains elevated but appears to have peaked. At the same time, the global manufacturing PMI, which typically leads global real bond yields by around six months, continues to climb to new cyclical highs. This suggests that the recent downdraft in global real bond yields could prove to be short-lived. Our Global Central Bank Monitor is climbing steadily, indicating greater upward pressure on bond yields from the combination of strong growth, rising inflation and loose financial conditions. Admittedly, bond yields are lagging the upward trajectory implied by the Monitor with central banks deliberately responding far more slowly to the cyclical pressures that would have triggered bond-bearish monetary tightening in the past. Nonetheless, the Monitor, the Global Duration Indicator and the global manufacturing PMI and all sending the same message – global bond yields remain too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US and Canada). We remain neutral the UK, although we have them on “downgrade watch” until there is greater clarity on how severely the spread of the Delta variant is impacting UK growth. The US remains the biggest underweight. The modestly hawkish turn by the Fed at the June FOMC meeting likely marked the end of the cyclical bear-steepening trend of the US Treasury curve. A full-blown turn to a bear-flattening of the US curve will be slow to develop, but we fully expect the cyclical pressures that drove the underperformance of longer-maturity US Treasuries over the past year to begin leaking into shorter-maturity bonds. That trend already appears to be underway with 5-year US yields starting to drift upward at a faster pace compared to other developed market peers (Chart 6). Chart 5Cyclical Indicators Suggest Global Yields Still Have More Upside Cyclical Indicators Suggest Global Yields Still Have More Upside Cyclical Indicators Suggest Global Yields Still Have More Upside Chart 6UST Underperformance Will Shift To Shorter Maturities UST Underperformance Will Shift To Shorter Maturities UST Underperformance Will Shift To Shorter Maturities This leads us to make a change to our model portfolio allocations this week, reducing the exposure to the belly of the US Treasury curve (the 3-5 year and 5-7 year maturity buckets), while modestly increasing the allocation to the 7-10 year bucket. To neutralize the duration-extending implication of that marginal shift, we added a new allocation to US Treasury bills, thus turning this US Treasury shift into a “butterfly” trade, essentially selling the 5-year bullet for a cash/10-year barbell. Longer-term Treasury yields, however, are still in the process of working off an oversold condition that developed in Q1 (Chart 7). Duration positioning remains quite short, according to the JP Morgan survey of bond investors, while speculators are still working off a huge net short position in 30-year Treasury futures according to data from the CFTC. We anticipate that it will take another month or two to work off such an extreme oversold condition for US Treasuries, based on similar episodes over the past two decades. After that, longer-maturity Treasury yields will begin to begin climbing again, to the benefit of the US underweight (and below-benchmark duration stance) in our model portfolio. Chart 7Longer-Maturity USTs Working Off Oversold Condition Longer-Maturity USTs Working Off Oversold Condition Longer-Maturity USTs Working Off Oversold Condition Chart 8A Sharply Diminished Impulse From Global QE A Sharply Diminished Impulse From Global QE A Sharply Diminished Impulse From Global QE Outside the US, the bond-friendly impact of quantitative easing programs is fading, on the margin, with the growth of central bank balance sheets slowing (Chart 8). While outright tapering of bond buying has only occurred in Canada and the UK (within our model bond portfolio universe), we expect the Fed to begin tapering in early 2022. Financial stability concerns are expected to play an increasingly important role in future tapering decisions, with house prices booming in many countries, most notably Canada which supports our underweight stance on Canadian government debt. Australia is the notable exception to this trend towards slowing balance sheet growth, with the Reserve Bank of Australia (RBA) maintaining a healthy pace of bond buying given underwhelming realized inflation. The recent wave of COVID-19 cases, which has left half of Australia under lockdowns that were largely avoided in 2020, will ensure that the RBA stays dovish for longer, to the benefit of our overweight stance on Australian government bonds. We continue to see the overall dovish stance of global central bankers as being conducive to the outperformance of inflation-linked bonds versus nominal government debt. However, inflation breakevens in most countries have largely completed the rebound from the depressed levels reached during the 2020 COVID-19 global recession. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are in Italy and France, with breakevens looking more stretched in the US, Canada and Australia (Chart 9). On the back of this, we are maintaining our allocations to inflation-linked bonds in the euro area in our model portfolio. Chart 9Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Chart 10Fading Support For Credit Markets From Global QE Fading Support For Credit Markets From Global QE Fading Support For Credit Markets From Global QE Moving our attention to the credit side of our model portfolio, we feel that a moderate overweight stance on overall global corporates versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets, as an indicator of the incremental shift away from the COVID-era monetary policies from 2020, is flashing a warning sign for the performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 10). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond excess returns around February 2022 Although given the current tight level of global corporate bond spreads, both for investment grade and high-yield, we expect future return outperformance from corporates versus government debt to come from carry rather than spread compression. Our preferred measure of the attractiveness of credit spreads is the historical percentile ranking of 12-month breakeven spreads, which measure how much spreads would need to widen to eliminate the carry advantage over duration-matched government bonds on a one-year horizon. Currently, only the lower-rated high-yield credit tiers in the US and euro area offer 12-month breakeven spreads above the bottom quartile of their history, within the credit sectors of our model portfolio (Chart 11). Chart 11Lower-Rated High-Yield Offers Relatively Attractive Spreads GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Given the sharply reduced default risks on both sides of the Atlantic, and with nominal growth in good shape amid low borrowing rates, we are maintaining our overweights to high-yield bonds in both the US and euro area. At the same time, we are sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce the overall corporate bond exposure later this year, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that signals about the future path for global monetary policy. Within the euro area, we continue to prefer owning Italian government bonds (and to a lesser extent, Spanish government debt) over investment grade corporates, given the more explicit support for the sovereigns through ECB quantitative easing (Chart 12). We expect the ECB to be the most accommodative central bank within our model portfolio universe over at least the next year, with even tapering of any kind unlikely in 2022. Chart 12Favor Italian BTPs Over Euro Area Investment Grade Favor Italian BTPs Over Euro Area Investment Grade Favor Italian BTPs Over Euro Area Investment Grade One area of the spread product universe where we are starting to reduce risk in the model portfolio is EM USD-denominated credit. EM debt has benefited from a bullish combination of global policy stimulus, a weakening US dollar and rising commodity prices over the past year. We have positioned for that in our model portfolio through an overall overweight stance on EM USD-denominated debt, but one that favors investment grade corporates over sovereigns. Now, all of those supportive factors for EM credit are fading. Chinese policymakers have reigned in both credit stimulus and fiscal stimulus this year, with the combined impulse suggesting a slower pace of Chinese economic growth in the latter half of 2021 (Chart 13). Given China’s huge share of the global consumption of industrial commodities, slowing Chinese growth should cool the momentum of commodity prices over the next few quarters. A slowing liquidity impulse from global central bank asset purchases is also a negative for EM debt performance, on the margin. The same can be said for the US dollar, which is no longer depreciating as markets start to pull forward the expected future path for US interest rates (Chart 14). A stronger US dollar typically correlates with softer commodity prices and wider EM credit spreads. Chart 13Major EM Risks: China Tightening & Global QE Tapering Major EM Risks: China Tightening & Global QE Tapering Major EM Risks: China Tightening & Global QE Tapering Chart 14EM Supportive USD Weakness Is Fading EM Supportive USD Weakness Is Fading EM Supportive USD Weakness Is Fading In response to these growing risks to the bullish EM backdrop - including the rapid spread of the Delta variant made worse by the less-effective vaccines available in those countries - we are downgrading our overall EM USD credit exposure in the model bond portfolio to underweight from neutral. We are doing this by cutting the EM corporate exposure from overweight to neutral, while maintaining an underweight tilt on EM USD sovereigns. We expect to further cut the EM exposure in the coming months by moving to a full underweight on EM corporates. Summing it all up, our overall allocations and risks in our model portfolio leading into Q3/2021 look like this: An overall below-benchmark stance on global duration, equal to nearly one full year versus the custom index (Chart 15) A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 16). This overweight comes almost entirely from overweight allocations to US and euro area high-yield corporate debt. Chart 15Overall Portfolio Duration: Stay Below Benchmark Overall Portfolio Duration: Stay Below Benchmark Overall Portfolio Duration: Stay Below Benchmark Chart 16Overall Portfolio Allocation: Small Spread Product Overweight GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks After the changes made to our US Treasury and EM positions, the tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is quite low at 34bps (Chart 17). The main reason for this is that our positioning remains focused heavily on the US (Treasury underweight, high-yield overweight), with much of the other positioning close to neutral or largely offsetting other positions in a relative value sense (overweight Australia vs underweight Canada, overweight US CMBS versus underweight US Agency MBS). This fits with our desire to maintain only a moderate level of overall portfolio risk. The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry”, hedged into USD, of 13bps (Chart 18). Chart 17Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Chart 18Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts After making the shifts to our model bond portfolio allocations in the US and EM, we now turn to scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. We see global growth momentum and the Fed monetary policy outlook as the two most important factors for fixed income markets in the second half of 2021, thus our scenarios are defined along those lines. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Base Case Global growth stays above-trend in both Q3 and Q4, putting downward pressure on unemployment rates and keeping realized inflation elevated. Ongoing global vaccinations lead to more of the global economy fully reopening, with the Delta variant not having serious widespread impact on economic confidence outside of parts of the emerging world. Excess savings built up during the pandemic are run down by both consumers and businesses as optimism stays ebullient within the developed economies. China credit tightening slows growth enough to cool off upward commodity price momentum. At the same time, falling US unemployment and surprisingly “sticky” domestic US realized inflation embolden the Fed to signal a move to begin tapering its bond purchases starting in January 2022. Real bond yields globally bottom out, while inflation expectations recover some of the pullback seen in Q2/2021. The entire US Treasury curve shifts higher, led by the 10-year reaching 1.65% and a modest bear-flattening of the 5-year/30-year curve. The VIX stays near 15, the US dollar rises +3%, the Brent oil price goes nowhere and the fed funds rate is unchanged at 0% Upside Growth Surprise The Delta variant proves to be far less deadly than feared. A rapid pace of global vaccinations leads to booming growth led by the US but including a fully reopened euro area. Chinese policymakers begin to reverse some of the H1/2021 credit tightening. Unemployment rates rapidly fall worldwide, while supply bottlenecks persist, keeping upward pressure on realized inflation. Markets pull forward the timing and pace of future central bank interest rate hikes, most notably in the US when the Fed begins tapering bond purchases sooner than expected before year-end. Real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve modestly bear-flattens, with the 10-year reaching 1.9% and the 5-year/30-year spread narrowing by 25bps. The VIX rises to 25 as risk assets struggle in response to rising bond yields even with faster growth. The US dollar falls -5% on the back of improving global growth expectations, the Brent oil price climbs +5% and the fed funds rate stays unchanged. Downside Growth Surprise The global economy gets hit on multiple fronts: the rapid spread of the Delta variant overwhelms the positive momentum on vaccinations, most notably in EM countries; Europe struggles to fully reopen; China policy tightening results in a larger-than-expected drag on global growth; and US households are reluctant to draw down on excess savings after government income support measures expire in September. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall in a risk-off move, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds rate stays at 0%. Chart 19Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 20US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis The inputs into the scenario analysis are shown in Chart 19 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 20. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks The model bond portfolio is expected to deliver a positive excess return over the next six months of +46bps in the base case scenario and +28bps in the optimistic growth scenario, but is projected to underperform by -36bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration stance, against a backdrop of persistent above-trend global growth and a highly stimulative fiscal/monetary policy mix. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations look the least stretched. We are making two changes to the portfolio allocations heading into Q3: shifting the Treasury curve exposure to have more of a flattening bias, while downgrading EM USD-denominated corporates to neutral. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks GFIS Model Bond Portfolio Q2/2021 Performance Review & Current Allocations: Hitting A Few Roadblocks Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Chart 4South Asia Is Characterized By Very Low Per Capita Incomes South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.

Highlights Gold is – and always will be – exquisitely sensitive to Fed policy and forward guidance, as last month's "Dot Shock" showed (Chart of the Week). Its price will continue to twitch – sometimes violently – as the widening dispersion of views evident in the Fed dots keeps markets on edge and pushes forward rate expectations in different directions. Fed policy is important but will remain secondary to fundamentals in oil markets. Increasingly inelastic supply will force refiners to draw down inventories, which will keep forward curves backwardated. OPEC 2.0's production-management policy is the key driver here, followed closely by shale-oil's capital discipline. Between these market bookends are base metals, which will remain sensitive to Fed policy, but increasingly will be more responsive to tightening supply-demand fundamentals, as the pace of the global renewables and EV buildout challenges supply. The one thing these markets will share going forward is increasing volatility. Gold volatility will remain elevated as markets are forced to parse sometimes-cacophonous Fed forward guidance; oil volatility will increase with steeper backwardation; and base metals volatility will rise as fundamentals continue to tighten. We remain long commodity-index exposure (S&P GSCI and COMT ETF) and equity exposure (PICK ETF). Feature Gold markets still are processing last month's "Dot Shock" – occasioned by the mid-June move of three more Fed bankers' dots into the raise-rates-in-2022 camp at the Fed – and the sometimes-cacophonous forward guidance of post-FOMC meetings accompanying these projections. Following last month's meeting, seven of the 18 central bankers at the June meeting now favor an earlier rate hike. This dot dispersion fuels policy uncertainty. When policy uncertainty is stoked, demand for the USD typically rises, which generally – but not always – contributes to liquidation of dollar-sensitive positions in assets like commodities. This typically leads to higher price volatility.1 This is most apparent in gold, which is and always will be exquisitely sensitive to Fed guidance and the slightest hint of a change in course (or momentum building internally for such a change). This is what markets got immediately after the June meeting. When this guidance reflects a wide dispersion of views inside the Fed, it should come as no surprise that price volatility increases among assets that are most responsive to monetary policy. This dispersion of market expectations – as a matter of course – is intensified by discordant central-bank forward guidance.2 Fundamentals Reduce Oil's Sensitivity To Fed Policy Fed policy will always be important for the evolution of the USD through time, which makes it extremely important for commodities, since the most widely traded commodities are priced in USD. All else equal, an increase in the value of the USD raises the cost of commodities ex-US, and vice versa. Chart of the WeekGold Still Processing Dot Shock Gold Still Processing Dot Shock Gold Still Processing Dot Shock Chart 2Oil Market Remains Tight... Oil Market Remains Tight... Oil Market Remains Tight... The USD's impact is dampened when markets are fundamentally tight – e.g., when the level of demand exceeds supply, as is the case presently for oil (Chart 2).3 When this occurs, refiner inventories have to be drawn down to make up for supply deficits (Chart 3). This leads to a backwardation in the oil forward curves – i.e., prices of prompt-delivery oil are higher than deferred-delivery oil – reflecting the fact that the supply curve is becoming increasingly inelastic (Chart 4). This backwardation benefits OPEC 2.0 member states, as most of them have long-term supply contracts with customers indexed to spot prices, and investors who are long commodity-index exposure, as it is the source of the roll yield for these products.4 Chart 3Forcing Inventories To Draw... Forcing Inventories To Draw... Forcing Inventories To Draw... Chart 4...And Backwardating Forward Curves ...And Backwardating Forward Curves ...And Backwardating Forward Curves Copper's Sensitivity To Fed Policy Declining Supply-demand fundamentals in base metals – particularly in the bellwether copper market – are tightening, which, as the oil market illustrates, will make prices in these markets less sensitive to USD pressures going forward (Chart 5). We expect the copper forward curve to remain backwardated for an extended period (Chart 6), which will distance the evolution of copper prices from Fed policy variables (e.g., interest rates and the USD). Chart 5Copper USD Sensitivity Will Diminish As Balances Tighten Copper USD Sensitivity Will Diminish As Balances Tighten Copper USD Sensitivity Will Diminish As Balances Tighten Chart 6Expect Persistent Backwardation In Copper Expect Persistent Backwardation In Copper Expect Persistent Backwardation In Copper Indeed, our modeling suggests this already is occurring in the metals markets, as can be seen from the resilience of copper prices during 1H21, when China's fiscal and monetary stimulus was waning and, recently, during the USD's recent rally, which was an unexpected headwind generated by the Fed's June meeting. If, as appears likely, China re-engages in fiscal and monetary stimulus in 2H21, the global demand resurgence for metals, copper in particular, will receive an additional fillip. Like oil, copper inventories will have to be drawn down over the next two years to make up for physical deficits, which have been a persistent problem for years (Chart 7). Capex in copper markets has yet to be incentivized by higher prices, which means these physical deficits likely will widen as the world gears up for expanded renewables generation and the grids required to support them, not to mention higher electric vehicle (EV) demand. If, as we expect, copper miners do not invest in new greenfield mine projects – choosing instead to stay with their brownfield expansion strategies – the market will tighten significantly as the world ramps up its demand for renewable energy. This means copper's supply curve will, like oil's, become increasingly inelastic. At the limit – i.e., if new mining capex is not incentivized – price will be forced to allocate limited supply, and may even have to get to the point of destroying demand to accommodate the renewables buildout. Chart 7Supply-Demand Balance Tightening In Copper Supply-Demand Balance Tightening In Copper Supply-Demand Balance Tightening In Copper A Word On Spec Positioning We revisited our modeling of speculative influence on these markets over the past couple of weeks, in anticipation of the volatility we expect and the almost-certain outcry from public officials that will ensue. Our modeling continues to support our earlier work, which found fundamentals are determinant to the evolution of industrial commodity prices. Using Granger-Causality and econometric analysis, we find prices mostly explain spec positioning in oil and copper, and not the other way around.5 We do find spec positioning – via Working's T Index – to be important to the evolution of volatility in WTI crude oil options, along with other key variables (Chart 8).6 That said, other variables are equally important to this evolution, including the St. Louis Fed's Financial Stress Index, EM equity volatility, VIX volatility and USD volatility. These variables are not useful in modeling copper volatility, where it appears fundamental and financial variables are driving the evolution of prices and, by extension, price volatility. We will continue to research this issue, and will continue to subject our results to repeated trials in an attempt to disprove them, as any researcher would do. Chart 8Oil Volatility Drivers Oil Volatility Drivers Oil Volatility Drivers Investment Implications Gold will remain hostage to Fed policy, but oil and base metals increasingly will be charting a path that is independent of policy-related variables, chiefly the USD. There is no escaping the fact that gold volatility will increasingly be in the thrall of US monetary policy – particularly during the next two years as the Fed attempts to guide markets toward something resembling normalization of that policy.7 However, as the events of the most recent FOMC meeting illustrate, gold price volatility will remain elevated as markets are forced to parse oftentimes-cacophonous Fed forward guidance. This would argue in favor of using low-volatility episodes as buying opportunities in gold options – particularly calls, as we continue to expect gold prices to end the year at $2,000/oz. We also favor silver exposure via calls, expecting price to go to $30/oz this year. In oil and base metals, we continue to expect supply-demand fundamentals in these markets to tighten, which predisposes us to favor commodity index products. For this reason, we remain long commodity-index exposure – specifically the S&P GSCI index, which is up 6.8% since inception, and the COMT ETF, which is up 8.7% since inception. We expect the base metals markets to remain very well bid going forward, and remain long equity exposure in these markets via the PICK ETF, which we re-entered after a trailing stop was elected that left us with a 24% gain since inception at the end of last year.   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 US crude oil stocks (ex SPR) fell 6.7mm barrels in the week ended 25 June 2021, according to the US EIA. Total crude and product stocks were down 4.6mm barrels. Domestic crude oil production was unchanged at 11.1mm b/d over the reporting week. Total refined-product demand surpassed the comparable 2019 reporting period, led by higher distillate consumption (4.2mm b/d vs 3.8mm b/d). Gasoline consumption remains a laggard (9.2mm b/d vs 9.5mm b/d), as does jet fuel (1.4mm b/d vs 1.9mm b/d). Propane and propylene demand surged over the period, likely on the back of petchem demand (993k b/d vs 863k b/d). Base Metals: Bullish Base metals prices are moving higher in anticipation of tariffs being imposed by Russia to discourage exports beyond the Eurasian Economic Union, according to argusmedia.com. In addition to export tariffs on copper, aluminum and nickel, steel exports also will face levies to discourage material from leaving the EAEU (Chart 9). The tariffs are expected to remain in place from August through December 2021. Separately, premiums paid for high-quality iron ore in China (65% Fe) reached record highs earlier this week, as steelmakers scramble for supply, according to reuters.com. The premium iron ore traded close to $36/MT over benchmark material (62% Fe) this week. Precious Metals: Bullish Gold prices continue to move lower following the FOMC meeting on June 16. The yellow metal was down 0.6% y-o-y at $1762.80/oz as of Tuesday’s close after being up a little more than 13% y-o-y before the FOMC meeting earlier this month (Chart 10). We believe the USD rally, which, based on earlier research we have done, could be benefitting from safe-haven demand arising from global concern over the so-called Delta variant of COVID-19, which has spread to at least 85 countries. Public-health officials are fearful this could cause a resurgence in COVID-19 cases and additional mutations in the virus if vaccine distribution in EM states is not increased. Ags/Softs: Neutral Widely disparate weather conditions in the US west and east crop regions – drought vs cooler and wetter weather – appear to be on track to produce average crop yields for corn and beans this year, according to agriculture.com's Successful Farming. In regions where hard red spring wheat is grown, states experiencing low rainfall likely will have poor crops this year. Chart 9 "Dot Shock" Continues To Roil Gold; Oil … Not So Much "Dot Shock" Continues To Roil Gold; Oil … Not So Much Chart 10 US Dollar To Keep Gold Prices Well Bid US Dollar To Keep Gold Prices Well Bid   Footnotes 1     We model gold prices as a function of financial variables sensitive to Fed policy – e.g., real rates and the broad trade-weighted USD – and uncertainty, which is conveyed via the Global Economic Policy Uncertainty (GEPU) index published by Baker, Bloom & Davis.  2     Please see Lustenberger, Thomas and Enzo Rossib (2017), "Does Central Bank Transparency and Communication Affect Financial and Macroeconomic Forecasts?" SNB Working Papers, 12/2017. The Swiss central bank researchers find "… the verdict about the frequency of central bank communication is unambiguous. More communication produces forecast errors and increases their dispersion. … Stated differently, a central bank that speaks with a cacophony of voices may, in effect, have no voice at all. Thus, speaking less may be beneficial for central banks that want to raise predictability and homogeneity among financial and macroeconomic forecasts. We provide some evidence that this may be particularly true for central banks whose transparency level is already high." (p. 26) 3    Please see OPEC 2.0 Vs. The Fed, published on February 8, 2018, for additional discussion. 4    Please see The Case For A Strategic Allocation To Commodities As An Asset Class, a Special Report we published on March 11, 2021 on commodity-index investing.  It is available at ces.bcaresearch.com. 5    The one outlier we found was Brent prices, for which non-commercial short positioning does Granger-Cause price.  Otherwise, price was found to Granger-Cause spec positioning on the long and short sides of the market. 6   Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published on April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. 7     Please see How To Re-Shape The Yield Curve Without Really Trying published by our US Bond Strategy group on June 22 for a deeper discussion of the outlook for Fed policy.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Dear Client, China Investment Strategy will take a summer break next week. We will resume our publication on July 14th. Best regards and we wish you a happy and healthy summer. Jing Sima, China Strategist   Highlights A USD rebound and higher domestic bond yields pose near-term challenges to Chinese risk assets. A sharp deceleration in credit growth in the past seven months will lead to weaker-than-expected data from China’s old-economy sectors in the second half of the year.  Robust global trade has propelled Chinese exports, allowing the country to pursue financial deleverage and structural reforms. However, next year policymakers will face increased pressure to support the domestic economy as the global economic recovery peaks and demand slows. Investors should maintain an underweight stance towards Chinese stocks in 2H21, but remain alert to any improvements in China’s policy tone.  An easing monetary policy may signal a potential upgrade catalyst in 1H22. Feature Most recent macro figures confirm that China’s impressive economic upcycle has peaked. We expect that the official manufacturing and non-manufacturing PMIs, which will be released as this report is published, will come in modestly down. We maintain the view that a major relapse in economic activity is unlikely, but the strong tailwinds that have propelled China's recovery since Q2 last year have since abated and will lead to softer growth. Meanwhile, the rate of economic and export expansions has given Chinese policymakers confidence to scale back leverage and continue with market reforms. In the second half of the year, investors' sentiment towards Chinese stocks will be tested based on three risks: A rebound in the US dollar index. A tighter liquidity environment and higher interest rates. A weakening in macro indicators beyond market expectations. As the global economic recovery peaks into 2022, pressures to support the domestic economy will become more urgent if policymakers want to maintain an average rate of 5% real GDP growth in 2020 - 2022. The current policy settings are not yet favorable to overweight Chinese risk assets. Major equity indexes remain richly valued and the market could easily correct if domestic rates move higher. However, signs of policy easing may emerge by yearend, which would prompt us to shift our view to overweight Chinese stocks in both absolute and relative terms. The Case For A Dollar Rebound On a tactical basis (next three months), a rebound in the US dollar index may curb investors’ enthusiasm for Chinese stocks. A stronger dollar will give the RMB’s appreciation some breathing room and will be reflationary for China’s economy. However, in the short term a stronger USD will also lead to weaker foreign inflows to China’s equity markets. Chinese stock prices have become more closely and negatively correlated with the dollar index since early 2020 (Chart 1). A weaker dollar is usually accompanied by a global economic upturn and a higher risk appetite from investors, propelling more foreign portfolio flows to emerging markets (which includes Chinese risk assets). Although foreign inflows account for a small portion of the Chinese A-share market cap, global institutional investors’ sentiment has become more influential and has led fluctuations in Chinese onshore stock prices (Chart 2). Chart 1Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Chart 2Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Chart 3Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff The US Federal Reserve delivered a slightly more hawkish surprise at its June FOMC meeting with the message that it will move the projected timing of its first fed fund rate liftoff from 2024 to 2023. Since then, market expectations have shifted from growth and inflation to focusing on the next monetary policy tightening phase, with the short end of the US yield curve rising sharply (Chart 3). Given that currency markets trade off the short end of the yield curve, higher US interest rate expectations will at least temporarily lift the US dollar. The timing and pace of the Fed’s tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the US central bank’s definition of “maximum employment.” BCA’s US Bond Investment strategist anticipates that sizeable and positive non-farm payroll surprises will start in late summer/early fall, which will catalyze a move higher in bond yields. As such, we expect additional upside risks in the dollar index in the coming months, which will discourage foreign investors’ appetite for Chinese equities. Bottom Line: A rebound in the dollar index will be a near-term downside risk to Chinese stocks. Risk Of Higher Chinese Interest Rates Another near-term risk to Chinese stock prices is a tightening in domestic liquidity conditions and a rebound in interest rates, particularly in Q3. Chart 4The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus So far this year the PBoC has kept liquidity conditions accommodative to avoid massive debt defaults, while allowing a faster deceleration in the pace of credit expansion and a sharp contraction in shadow banking (Chart 4). In the coming months, however, the trend may reverse. Even though we do not think China’s current inflation and growth dynamics warrant meaningful and sustainable monetary policy tightening, there is still room for rates to normalize to their pre-pandemic levels in the next few months. Our view is based on the following:  First, there was a major delay in local government bond issuance in the first five months of the year. The supply of government bonds will pick up meaningfully in Q3 to meet the annual quota for 2021. An increase in government bond issuance will remove some liquidity from the banking system because the majority of these local government bonds are purchased by commercial banks. Adding to the liquidity gap is a large number of one-year, medium-term lending facility (MLF) loans that will be due in 2H21. Secondly, the PBoC may shift its policy tightening from reducing the volume of total credit creation (measured by total social financing) to raising the price of money. Credit growth (on year-over-year basis) in the first five months of 2021 dropped by three percentage points from its peak in Q4 last year, much faster than the 13-month peak-to-trough deceleration during the 2017/18 policy tightening cycle. As the rate of credit creation approaches the government’s target for the year, which we expect around 11%, the pressure to further compress credit expansion has eased into 2H21. China’s policy agenda is still focused on de-risking in the financial and real estate sectors, therefore, we expect policymakers to keep overall monetary conditions restrictive by raising the price of money. Furthermore, we do not rule out the possibility of a hike in mortgage rates. Chart 5Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Lastly, as the Fed prepares market expectations for its rate liftoff and China’s domestic economy is still relatively solid, the PBoC may seize the opportunity to guide market-based interest rates towards their pre-pandemic levels. Thus, the market will likely price in tighter liquidity conditions while lowering expectations for the economy and inflation. The short end of the yield curve will rise faster than the longer end, resulting in a flattening of the curve (Chart 5). There is a nontrivial risk that the market will react negatively to tighter liquidity conditions and rising bonds yields, particularly when the economy is slowing. We mentioned in previous reports that rising policy rates and bond yields do not necessarily lead to lower stock prices, if rates are rising while credit keeps expanding and corporate profit growth accelerates. However, currently credit impulse has decelerated sharply, and corporate profit growth has most likely peaked in Q2. Therefore, even a small increase in bond yields or market expectations of higher rates will likely trigger risk asset selloffs. Bottom Line: Bond yields will move higher in Q3, risking market selloffs. Chinese Economy Standing On One Leg China’s economic fundamentals also pose downside risks to Chinese stock prices. Macro indicators on a year-over-year comparison will soften further in 2H21 when low base effects wane, although they will weaken from very high levels. This year’s sharp credit growth deceleration will start to drag down domestic demand, with the risk of corporate profits disappointing the market. A positive tailwind from global trade prevented China's old economy from decelerating more in the first half of the year. It is reflected in the nominal imports and manufacturing orders components in the BCA Activity Index (Chart 6). However, while rising commodity prices boosted the value of Chinese imports, the volume of imports has been moving sideways of late (Chart 7). Chart 6Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Chart 7...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over Chart 8Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Moreover, China’s export volume is peaking as the reopening in other countries shifts consumer demand from goods to services. Strong export growth would likely decelerate and converge to global industrial production growth in the coming 12 months, even though a regression-based approach suggests that export growth will stay above trend-growth if global economic activity remains robust (Chart 8). All three components of the official Li Keqiang Index, which measures China’s industrial sector activity and incorporates electricity consumption, railway transportation and bank lending, have rolled over (Chart 9). Among the three components in BCA’s Li Keqiang Leading Indicator, only the monetary conditions index improved on the back of lower real rates. Contributions from the money supply and credit expansion components to the overall indicator have been negative (Chart 10). Chart 9The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... Chart 10...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator Chart 11Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard The recovery in household consumption remains well behind the industrial sector in the current cycle (Chart 11). We expect consumption and services to continue recovering very gradually. Apart from China’s long-standing structural issues, such as sliding household income growth and a high propensity to save, the cyclical recovery in consumption is dependent on China’s domestic COVID-19 situation. The country is on track to fully vaccinate 40% of its population by the end of June and 80% by year-end (Chart 12). However, hiccups in the service sector recovery are expected through 2H21, given China’s “zero tolerance” policy on confirmed COVID cases, which could trigger sporadic local lockdowns (Chart 13). Chart 12China Is Racing To Reach “Full Inoculation Rate” By Yearend China Outlook: A Mid-Year Recap China Outlook: A Mid-Year Recap Chart 13Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Bottom Line: Any moderation in exports in the rest of 2021 may add to the slowdown in China’s economic activity. Don’t Count On Fiscal Support Chart 14Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 During the first five months of the year, fiscal spending has downshifted (Chart 14). The amount of local government special-purpose bonds (SPBs) issued was far less than in the same period of the past two years, and below this year’s approved annual quota. Although we expect fiscal support to increase into 2H21, backloading SPBs would qualify, at best, as a remedial measure rather than a meaningful boost to economic activity. The RMB3 trillion SPBs to be issued in 2H21 represent only about 10% of this year’s total credit expansion. To substantially boost credit impulse and economic activity, the pickup in SPB issuance will need to be accompanied by looser monetary policy and an acceleration in bank loans (Chart 15). We do not expect that liquidity conditions will remain as lax as in 1H21. Additionally, given that the central government’s focus is to rein in the leverage of local governments and their affiliated financial vehicles (LGFV), provincial officers have little incentive to take on more bank loans against a restrictive policy backdrop. Historically, a stronger fiscal impulse linked to hefty increases in local government bond issuance has not necessarily led to meaningful improvements in infrastructure investment, which has been on a structural downshift since 2017 (Chart 16). Following a V-shaped recovery in 2H20, the growth in infrastructure investment will likely continue to slide in 2H21 due to sluggish government spending. Chart 15Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Chart 16Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Bottom Line: There are no signs that the overall policy stance is easing to facilitate a higher fiscal multiplier from an upturn in local government bond issuance. As such, fiscal support for infrastructure spending and economic activity will disappoint in 2H21 despite more SPB issuance. Investment Conclusions Monetary conditions may tighten in Q3 although credit growth will decelerate at a slower pace. Pressures to support domestic demand will be more pronounced next year as tailwinds abate from the global recovery and domestic massive stimulus. Our view is that Chinese authorities will likely ease on the policy tightening brake towards the end of this year and perhaps even signal some reflationary measures in early 2022.  Therefore, while we maintain an underweight stance on Chinese stocks for the time being, investors should remain alert to any improvements in China's policy direction. In particular, any monetary policy easing by end this year/early 2022 may signal a potential catalyst to upgrade Chinese stocks to overweight in absolute terms. Although both Chinese onshore and investable equities are currently traded at a discount relative to global stocks, they are richly valuated compared with their 2017/18 highs (Chart 17). China's economy is slowing and the corporate sector has substantially increased its leverage in the past decade. We believe that the current discount in Chinese equities relative to global stocks is warranted. Chart 18 presents a forecast for A-share earnings growth in US dollars, based on earnings’ relationship with the official Li Keqiang index. The chart shows that while an earnings contraction is not probable, without more stimulus the growth rate may fall sharply in the next 12 months from its current elevated level. This aspect, combined with only a minor valuation discount relative to global stocks, paints an uninspiring outlook for Chinese onshore stocks. Chart 17Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chart 18An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook Our baseline view is that Chinese authorities will be more willing to step up policy supports into 2022. Fiscal impulse will likely turn negative for most major economies next year and global economic recovery will have peaked. In this scenario, both China’s economy and stocks will have the potential to outperform their global peers next year.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations