Financial Markets

On Friday 4th June, I will be debating my colleague Peter Berezin on the future of cryptocurrencies. I believe that the cryptocurrency asset-class has substantial further price upside, whereas Peter thinks that it is going to zero. So please join us for what will be a lively debate on Friday 4th June at 10am EDT, (3pm BST, 4pm CEST). Dhaval Joshi Feature Chart of the WeekThe Fractal Structure Of Cryptos Had Become Very Fragile The Fractal Structure Of Cryptos Had Become Very Fragile The Fractal Structure Of Cryptos Had Become Very Fragile Today’s report is a brief review and update of the 22 short-term trades that we have recommended through the past three months, and it demonstrates the power of Fractals: The Competitive Advantage In Investing. At the end of the report we also introduce a new trade. Our 22 recommendations have comprised 10 structured trades – which include profit-targets, symmetrical stop-losses, and expiry dates – plus a further 12 recommendations without structured exit points. In summary, three structured recommendations have hit their profit targets: short NOK/PLN +2.6 percent, long European Personal Products versus Autos +15 percent, and long Finland versus Sweden +4.7 percent. Two open trades are in profit, and one is flat. Against this, two structured recommendations hit their stop-losses: short GBP/JPY -2.2 percent, and long New Zealand versus MSCI ACWI -4 percent. Meanwhile, long China versus Netherlands reached its expiry date at a slight loss -1.8 percent. And one open trade is in loss. This results in a ‘win ratio’ at a commendable 55 percent – counting a ‘full win’ as hitting the profit target, a ‘full loss’ as hitting the symmetrical stop-loss, and pro-rata for partial wins and losses. The win ratio at 55 percent is commendable because, in recent months, all financial assets been strongly correlated to the ebb and flow of bond yields and the ‘reflation trade’ – as we highlighted in The Pareto Principle Of Investment. This has made the current environment a difficult one to find genuinely independent investment ideas. Even more commendably, the 12 unstructured recommendations, which included Bitcoin, Ethereum, and several commodities, have all anticipated exhaustions or sharp reversals. The sections below review the structured and unstructured recommendations in chronological order. The 10 Structured Recommendations 1.            18th March: Short NOK/PLN                 Achieved its +2.6 percent profit target. 2.            25th March: Short GBP/JPY                 Hit its -2.2 percent stop-loss. 3.            1st April: Long European Personal Products vs. European Autos                 Achieved its +15 percent profit target. 4.            15th April: Long China vs. Netherlands                 Expired at -1.8 percent (versus its +5 percent profit target). 5.            15th April: Long Finland vs. Sweden                 Achieved its +4.7 percent profit target. 6.            22nd April: Long New Zealand vs. MSCI ACWI                 Hit its -4 percent stop-loss. 7.            6th May: Short Building and Construction (PKB) vs. Healthcare (XLV)                 In profit, and we expect further upside (Chart I-2). Chart I-2Short Building And Construction Versus Healthcare Short Building And Construction Versus Healthcare Short Building And Construction Versus Healthcare 8.            6th May: Short France vs. Japan                 In loss, but we expect upside. 9.            13th May: Long USD/CAD                 Flat, but we expect upside. 10.          20th May: Long 10-year T-bond vs. 10-year TIPS                 In profit, and we expect further upside (Chart I-3). Chart I-3Short Inflation Expectations Short Inflation Expectations Short Inflation Expectations The 12 Unstructured Recommendations 1.            18th March: Stocks vs. Bonds (MSCI ACWI vs. 30-year T-bond) to consolidate                 As anticipated, global stocks have consolidated versus bonds since mid-March, and we expect the consolidation to continue. 2.            18th March: Long 30-year T-bond                 Likewise, exactly as anticipated, bond prices have rebounded since mid-March, and we expect the rebound to continue (Chart I-4). Chart I-4Bond Prices To Rebound Bond Prices To Rebound Bond Prices To Rebound 3.            25th March: Tactically short Bitcoin                 Bitcoin subsequently corrected by almost 40 percent, but the correction is mostly done (Chart I-1).   4.            25th March: Tactically short Ethereum                 Likewise, Ethereum subsequently corrected, but the correction is mostly done. 5.            15th April: Short Taiwan vs. China                 Taiwan subsequently corrected versus   China, but the correction is mostly done. 6.            22nd April: Short PKR/USD                 As anticipated, PKR/USD corrected in the subsequent month. 7.            6th May: Short Corn vs. Wheat 8.            6th May: Short Timber (Chart I-5) Chart I-5Short Timber Short Timber Short Timber 9.            13th May: Short Soybeans 10.          20th May: Short Copper 11.          20th May: Short Tin 12.          27th May: Short Iron Ore                 As anticipated, all the above commodities have corrected, and in some cases very sharply. But the correction is still underway. New Recommendation Finally, this week’s new recommendation comes from the MSCI world equity index universe. The massive outperformance of Austria versus Chile – in large part due to the different sector compositions of the two markets – is fragile on all fractal dimensions: 65-day, 130-day, and 260-day (Chart I-6). Chart I-6Short Austria Vs. Chile Short Austria Vs. Chile Short Austria Vs. Chile Accordingly, the recommendation is to short Austria versus Chile, setting the profit target and symmetrical stop-loss at 7 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart I-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart I-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart I-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights President Biden’s FY2022 budget largely confirms consensus views of the economy – which means that it overrates the government’s tax-collecting powers and underrates its fiscal profligacy. The US fiscal thrust will turn negative as the budget deficit contracts in the coming years but the private economic recovery looks robust and positive government spending surprises will mitigate the fiscal cliff. The Biden administration may attempt to pass its capital gains tax hike in the next budget reconciliation bill and make it retroactive to 2021. We doubt this will occur but investors will need to book some profits to be on the safe side. Big Tech still faces a “slow boil” when it comes to government regulation. Stay long materials and infrastructure relative to tech. We were stopped out of our long energy large caps trade. The energy sector is still a beneficiary of a strong macro backdrop for oil and commodities. Close our long municipal bonds trade for a gain of 2%. Feature President Biden’s budget proposal for fiscal 2022 is a confirmation of macro policy trends that the market is well aware of and has already priced. The presidential budget, released on May 27, is a symbolic document. Congress controls the purse strings and congressional dynamics will work out differently from what the White House intends. Still, the budget is significant for highlighting the administration’s big spending preferences and the critical structural theme: the return of Big Government. That is not to say that Biden will fail to overcome various checks and balances with regard to his major legislative priorities, the American Jobs Plan (AJP) and American Families Plan (AFP). Biden’s measurable political capital is still moderate-to-strong. His popular approval remains above 50% and slightly improved in the latest opinion surveys (Chart 1). It should stay above the halfway line as the economy recovers. Chart 1ABiden’s Approval Rating Holding Up Forget Biden's Budget Forget Biden's Budget Chart 1BBiden’s Approval Rating Holding Up Forget Biden's Budget Forget Biden's Budget Consumer confidence improved again in May, on the back of what promises to be a rollicking disease-free summer for households. Political polarization continued to abate in the wake of the contested 2020 election. It may be hitting resistance levels (we expect polarization to remain elevated despite dropping off from Trump-era peaks) but the market implications will only become relevant after Biden’s legislative agenda grinds to a halt following the passage of his second reconciliation bill. Polarization will revive around September with the debt ceiling and the 2022 budget appropriations process and ahead of the 2022 midterm elections, which have a subjective 75% chance of gridlocking Congress. But that time has not yet come and Biden is still capable of signing one or two major bills into law. New data on government spending underscores the big government trend. Fiscal thrust – in this case the unadjusted change in the budget deficit – grew substantially in the first quarter of 2021 relative to the fourth quarter of 2020. It went from 4.6% of GDP in Q4 to 13.1% of GDP in Q1, an increase of 8.5%. The budget deficit will contract in the coming years, a headwind for the economy, but not too dangerous of a headwind as long as the private economy continues to recover, as it should. Real wages are growing at a steady pace, leaping up from a 1.9% growth rate in November to 11.7% in April. What is more notable is the continued decline in consumer loan delinquencies from 1.8% to 1.7% in the first quarter – i.e. flat and marginally declining. It is impressive that the US suffered a recession without considerable consumer or business bankruptcies or delinquencies. When government support ends – when the moratorium on home evictions expires this month and unemployment insurance dries up in September 6 – it will be critical to watch for an increase in distress to determine if the Fed will become more or less inclined to taper asset purchases, the preliminary to raising interest rates. Given that the pandemic caused the recession, and that the pandemic is ebbing on the back of vaccinations, our base case is that the private economy will recover even as government support declines. Most of the good news of the US recovery and government stimulus is priced into the market. Investors will now focus on the Federal Reserve and the passage of Biden’s two big bills. We agree with the BCA House View that the Fed will deliver dovish surprises despite the improving economy as it cannot afford to renege on its new monetary policy strategy but must convince the market that it remains dedicated to an inflation overshoot. Biden’s Budget In A Few Simple Charts Biden’s first presidential budget projects a sea change in US government spending, a “normalization” in US government taxation (reversal of President Trump’s tax cuts), and an economy whose underlying conditions remain the same despite the policy sea change. In reality the economy will respond to the sea change in policy. Real economic growth is projected to slow from 5.2% this calendar year to 4.3% in 2022 and then to settle at around 2% through 2031 (Chart 2). This is in line with forecasts from the Congressional Budget Office and consensus expectations of potential GDP growth. Productivity and labor force growth, which make up potential GDP, are hard to predict. We would note that the Biden administration has drastically cut back on immigration law enforcement. It will be hard to dislodge the Democrats in 2024 given that the economy will be robust and the Republican Party is divided. Therefore immigration policy will not undergo a substantial tightening at least through 2028, though bipartisan immigration reform is possible after 2022 and would marginally tighten inflows. Chart 2Presidential Budget Growth Rate Assumption Forget Biden's Budget Forget Biden's Budget Meanwhile a substantial increase in federal funding for infrastructure, research and development, and STEM education could improve productivity later in the decade, if only on a cyclical rather than structural basis. In other words the administration is not too optimistic regarding growth assumptions even though it assumes higher growth than the Fed or CBO. Inflation is expected to peak at 2.3% in 2025 and continue at that rate throughout the decade (Chart 3). We will not enter into the inflation debate here. Suffice it to say that the risk lies to the upside despite the above points regarding potential growth. Republican voters have abandoned any semblance of fiscal austerity, as signified by President Trump’s success, while the Democrats under Biden are flirting with modern monetary theory. The Fed has adopted a new monetary policy that is aimed at fighting deflationary tail risks at all costs. The budget deficit and trade deficit are ballooning and the US dollar is weakening. The US has fundamentally shifted trade policy, at least with regard to China, which is pushing up input costs. Chinese and global demographics imply a falling ratio of workers to dependents, which implies a secular rise in wages. Chart 3Presidential Budget Inflation Assumption Forget Biden's Budget Forget Biden's Budget In terms of taxing and spending, the presidential budget is overly optimistic about the ability of the federal government to maintain policy orthodoxy. Budgetary receipts are expected to rise on Biden’s tax hikes and the expiration of the Trump tax cuts in 2025. This is exaggerated, since Biden has already said he will accept a corporate tax hike half as large as that in the budget (25% instead of 28%). It is true that finding the votes to extend the Trump tax cuts will be politically difficult and the expiration date arrives at the beginning of a new administration in a non-election year when some fiscal tightening is manageable. But the projection that spending will stay stable at less than 25% of GDP despite Biden’s “Great Society”-style spending is infeasible (Chart 4). Chart 4Presidential Budget Tax-And-Spend Assumptions Forget Biden's Budget Forget Biden's Budget Major spending cuts are far less likely in the foreseeable future than they were back in 2011, when the Budget Control Act was passed. True, Republicans will rediscover their fiscal rectitude in the opposition. But in a social environment of populism and anti-austerity they will either fail to obtain full control of Congress or they will fail to execute deep spending cuts. The party’s political base is now the working class so it will have to rethink cuts to entitlements (mandatory spending), just as it is already rethinking its commitment to corporate tax cuts. Democrats will not cut mandatory or non-defense discretionary spending and will oppose any Republican efforts aggressively (Chart 5). Chart 5Presidential Budget Mandatory Versus Discretionary Spending Forget Biden's Budget Forget Biden's Budget While the presidential budget envisions stable defense spending, the truth is that the one area where Republicans are likely to succeed in influencing fiscal policy substantially lies in defense, which will grow. The US is phasing out its “small wars” and focusing on struggle among the Great Powers. Biden anticipates that defense spending will be flat while non-defense rises sharply but this is unlikely to occur. Regardless of Biden’s specific budget, the US is engaged in the largest government spending since the 1940s and yet there is neither a Great Depression nor a World War II taking place. However, this extravagant peacetime spending looks less extravagant when one considers that there are some historical parallels to the 1930s-40s. There have been two major economic shocks over the past 13 years and there is an emerging cold war with China. The US public has taken a populist turn, the political establishment is determined to provide more largesse to win back the hearts and minds of the people, and the defense and intelligence establishment are well aware of the rising security threats from China and Russia. Federal spending will persistently surprise to the upside while tax hikes could be stymied as early as the 2022 midterm elections. The result is a larger-than-expected budget deficit. The implication for the short-to-medium term is higher inflation and a weaker US dollar. But soaring geopolitical conflict and China’s structural slowdown will eventually put a floor under the dollar. Fiscal Thrust And Budget Deficit Projections Financial markets are already pretty well aware of these trends. The FY2022 presidential budget, which assumes that Biden’s entire legislative agenda passes Congress, does not project a budget deficit that is very different from a back-of-the-envelope “Status Quo” scenario, which assumes that the American Jobs and Families Plans do not pass (Chart 6). Chart 6Presidential Budget Deficit Scenario Alongside Previous Scenarios Forget Biden's Budget Forget Biden's Budget Of course, the AJP, at least, is likely to pass. If a bipartisan deal is struck this week or shortly thereafter then full passage is possible by the end of July. The Democrats would then spend the entire fall legislative session crafting a bill that combines some of the remaining portions of the AJP with the high-priority parts of the AFP into a single budget reconciliation bill that would be likely to pass by Christmas or early 2022. Nevertheless Biden’s budget reveals that there is not much distance in budget deficit projections with regard to the AFP (Chart 7). Even though the price tag of the AFP is huge, at $1.8 trillion, the truth is that it will be watered down in negotiation and it will also be accompanied by at least some tax hikes. Thus the market already has most of the information it needs regarding US budget deficit projections. Everything else depends on events in the private economy and external sector. The good news of the US budget deficit blowout is largely priced. Future upward surprises in the deficit, which we expect, serve to mitigate the contraction in the budget deficit, i.e. to reduce the negative fiscal thrust that drags on the economy as stimulus wanes. In other words the looming “fiscal cliff” is probably overrated from an economic point of view even though it may contribute to a pullback in the stock market. Chart 7Small Difference Between Biden’s Two Plans Forget Biden's Budget Forget Biden's Budget Changes In The Post-Infrastructure Agenda After Biden passes his infrastructure plan (the AJP), whether via bipartisanship or reconciliation, the AFP presents a much tougher political slog in Congress. The revised AFP promises to be a Frankenstein monster of social spending – a new “Alphabet Soup” of government programs including affordable child care, elderly care, universal pre-kindergarten schooling, subsidized community college, and paid leave. It will have to be pared back somewhat to appease moderate Democratic senators. The administration has tried to pitch the new social spending as “human infrastructure,” since infrastructure is more popular than welfare, but while Democrats accept this rhetorical gimmick, a majority of independent voters (along with opposition Republicans) apparently do not (Chart 8). Still the AFP could very well pass before the midterm on the condition that Biden signs the AJP this summer. We stick with our 50/50 odds for now. Chart 8Much Tougher Slog On Social Spending Bill Forget Biden's Budget Forget Biden's Budget The presidential budget introduced a new risk regarding the impending capital gains tax hike: the possibility that it will be enacted retroactively, taking effect in 2021, rather than in 2022 or thereafter as expected. The administration proposes to raise the long-term capital gains rate to 39.6%, which, combined with the Obamacare surtax of 3.8% would result in a 43.4% rate on capital gains for investors making over $1 million. A compromise will be necessary but the top rate could still end up above 32%. If Biden completes a bipartisan infrastructure deal this summer then he is much more likely to get this and other individual tax hikes into the reconciliation bill at the end of this year. Retroactivity is possible but it would be bad politics ahead of the midterm election. Therefore we stick with our view that individual tax hikes will take effect in 2023 if at all. But from a prudential perspective, investors will have to book some gains to prepare for negative tax surprises and that suggests near-term profit taking could weigh on the stock market (Chart 9). Chart 9A Retroactive Capital Gains Tax? A Retroactive Capital Gains Tax? A Retroactive Capital Gains Tax? Since Biden is guaranteed to get a lot of spending through two or three reconciliation bills (one already passed), he will not get much when it comes to regular appropriations. We are more likely to see the GOP refuse to cooperate on budgetary appropriations. This could lead to a debt ceiling crisis and government shutdown at the end of this year or early next year; hence the aforementioned return of polarization. However, these events will play out very differently from 2011-13. The GOP must tread carefully as they are already divided among pro-Trump and anti-Trump factions and will suffer even worse in public support if they induce a shutdown. A government shutdown would not be market negative in an already highly stimulated economy but it could jeopardize Republican odds in 2022, thus marginally increasing the risk of upward surprises in Democrats’ tax-and-spend policies. Congress is also moving forward on a raft of other legislative proposals, highlighted in Table 1. Most of these proposals will fall short of the bipartisan support necessary to get the required 60 votes in the Senate. The most promising bills involve efforts to resurrect US industrial policy, research and development, technological leadership (particularly in semiconductors), supply chain resilience, and domestic manufacturing. Anything that aims to coordinate the two parties in the face of geopolitical competition with China is likely to pass, as we have highlighted in our sister Geopolitical Strategy service. The result, as mentioned above, is likely to be a cyclical uptick in productivity (we will not speculate here on whether the structural downtrend will be broken). Table 1Pending Legislation In Congress Under Biden Forget Biden's Budget Forget Biden's Budget The Slow Boil Of Tech Regulation In a recent report on the Biden administration’s regulatory threat to the tech sector we argued that while popular opinion and government interest were creating a “slow boil” for Big Tech, nevertheless the reflationary macroeconomic backdrop posed a much larger short-term risk. We stand by this view especially in light of recent developments. In particular, legislative priorities, gridlock in all key agencies, slow movement in the Department of Justice’s staffing, an evenly divided Senate, and a recent Supreme Court judgement against the Federal Trade Commission all lend confirmation to our thesis, at least for now. To elaborate: A bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart 10) and this consensus grew substantially over the controversial 2020 political cycle. However, not all surveys show strong majorities in favor of regulation, even if they show strong majorities are skeptical of Big Tech’s influence. And Republicans and Democrats disagree on the aims of regulation, with Republicans averse to “content moderation,” or ideological censorship, and Democrats eager to retain their advantage in political fundraising from Silicon Valley. Any bill requiring 60 votes in the Senate would be an opportunity for Republicans to demand that their speech and press rights be preserved, which would be a poison pill for Democrats. The lack of cooperation on the proposed commission to investigate the January 6 riot at the US Capitol highlights the inability to bridge the ideological gap. Chart 10Bipartisan Consensus On Tech Regulation Forget Biden's Budget Forget Biden's Budget Most of the Democrats’ political capital will be spent on passing the infrastructure bill and the next budget reconciliation bill. There is limited space for other legislation, aside from the strategic competition with China. Minnesota Senator Amy Klobuchar’s anti-trust efforts, including parts of the Competition and Antitrust Enforcement Reform Act, have some chance of passage. She has proposed steps that Republicans can agree on, such as increasing fees on big mergers to fund anti-trust agencies, preventing anti-competitive pricing, and protecting whistleblowers. Her main bill avoids the debate over censorship and arguably preserves the almighty “consumer welfare” standard for determining where harm has occurred and government intervention may be necessary. Republican Senator Mike Lee of Utah has said some positive things about the bill and argues that it would not replace consumer welfare (though not all Republicans will agree and the judicial system will separately defend the consumer welfare standard). Regulatory reform is far more effective when backed by a new legislative overhaul. For example, reform of Section 230 of the Communications Decency Act becomes more difficult without new legislation. Regulation via the executive branch can be important but requires focus from the president and a strong consensus in key positions in the bureaucracy. Democrats must confirm two nominations to the Federal Communications Commission, which is currently deadlocked, in order to achieve a partisan majority and make headway on policy priorities (Table 2). Cybersecurity, net neutrality, and overseeing broadband internet expansion will compete with any regulatory probes into Big Tech. The Senate will also have to confirm two nominations for the Federal Trade Commission, which is also deadlocked at the moment (Table 3). One of these, for anti-trust scholar Lina Khan, a critic of Big Tech, is in process. Yet the FTC has possibly lost some of its bite after a Supreme Court ruling in April (AMG Capital v. FTC) determined that the agency cannot seek monetary relief under one of its most frequently used legal authorities (Section 13b of the Federal Trade Commmission Act). The FTC will thus lose some ability to impose penalties, particularly in consumer protection cases. Facebook is already attempting to use this ruling to dismiss the FTC’s case against it, which could result in a forced sale of popular subsidiaries WhatsApp and Instagram. Table 2Balance Of Power On The FCC Forget Biden's Budget Forget Biden's Budget Table 3Balance Of Power On The FTC Forget Biden's Budget Forget Biden's Budget As for the Department of Justice, while Biden’s appointments have all been confirmed, the anti-trust division is bogged down by ethics concerns since several officials would have to recuse themselves in cases against Big Tech due to their previous work representing plaintiffs against Big Tech. The bottom line is that Big Tech is in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as Big Banks faced tougher regulation in the wake of the subprime mortgage crisis. Both public and government willingness to prosecute and regulate Big Tech have gone up, creating a permanently higher level of regulatory risk. Yet government focus and capability are lacking in the short run. Investment Takeaways Most of the major reflation trades have taken a pause in recent weeks, as expected. The stock-to-bond ratio has stalled, the cyclicals to defensives ratio has peaked twice, and TIPS have lost momentum relative to duration-matched nominal treasuries. The big five tech firms’ shares have tentatively arrested their fall relative to the other 495 companies on the S&P500. It is not clear if they will break down further but the above analysis suggests that they will. We are sticking with our long materials / short tech trade (Chart 11). Chart 11Long Materials Versus Technology Long Materials Versus Technology Long Materials Versus Technology Investors should stay invested, maintain pro-cyclical trades, favor value stocks relative to growth stocks, but avoid taking on large new risks in the current environment. The post-vaccine rally has lost steam but the overall macro backdrop remains favorable as the global economy recovers. We are closing our long municipal bonds trade for a gain of 2.3%. Our large cap energy trade has stopped out at -5% with small caps outperforming in the face of regulatory and ESG headwinds for the supermajors. Biden’s regulatory risk to energy small caps has been outweighed by the macro context but will become relevant at some point.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Appendix Table A1USPS Trade Table Forget Biden's Budget Forget Biden's Budget Table A2Political Risk Matrix Forget Biden's Budget Forget Biden's Budget Table A3Political Capital Index Forget Biden's Budget Forget Biden's Budget Table A4APolitical Capital: White House And Congress Forget Biden's Budget Forget Biden's Budget Table A4BPolitical Capital: Household And Business Sentiment Forget Biden's Budget Forget Biden's Budget Table A4CPolitical Capital: The Economy And Markets Forget Biden's Budget Forget Biden's Budget  

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles China's Decade Of Troubles China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary Global Investors Still Wary Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia Constraints On China's Tarrifs On Australia Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit US Tarrifs Reduce China In Trade Deficit US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage US Export Controls Amid Chip Shortage US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing China's Growth Potential Slowing China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China's Leaders Struggle With Debt China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Global Stock-To-Bond Ratio Rolled Over Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Chart 14Global Large Caps Catch A Bid Versus Small Caps Global Large Caps Catch A Bid Versus Small Caps Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights China's high-profile jawboning draws attention to tightness in metals markets, and raises the odds the State Reserve Board (SRB) will release some of its massive copper and aluminum stockpiles in the near future. Over the medium- to long-term, the lack of major new greenfield capex raises red flags for the IEA's ambitious low-carbon pathway released last week, which foresees the need for a dramatic increase in renewable energy output and a halt in future oil and gas investment to achieve net-zero emissions by 2050. Copper demand is expected to exceed mined supply by 2028, according to an analysis by S&P, which, in line with our view, also sees refined-copper consumption exceeding production this year (Chart of the Week). A constitution re-write in Chile and elections in Peru threaten to usher in higher taxes and royalties on mining in these metals producers, placing future capex at risk. Chile's state-owned Codelco, the largest copper producer in the world, fears a bill to limit mining near glaciers could put as much as 40% of its copper production at risk. We remain bullish copper and look to get long on politically induced sell-offs as the USD weakens. Feature Politicians are inserting themselves in the metals markets' supply-demand evolutions to a greater degree than in the past, which is complicating the short- and medium-term analysis of prices. This adds to an already-difficult process of assessing markets, given the opacity of metals fundamentals – particularly inventories, which are notoriously difficult to assess. Chinese Communist Party (CCP) jawboning of market participants in iron ore, steel, copper and aluminum markets over the past two weeks has weakened prices, but, with the exception of steel rebar futures in Shanghai – down ~ 17% from recent highs, and now trading at ~ 4911 RMB/MT –  the other markets remain close to records.  Benchmark 62% Fe iron ore at the port of Tianjin was trading ~ 4% lower at $211/MT, while copper and aluminum were trading ~ 5.5% and 6.5% off their recent records at $4.535/lb and $2,350/MT, respectively. In addition to copper, aluminum markets are particularly tight (Chart 2). Jawboning aside, if fundamentals continue to keep prices elevated – or if we see a new leg up – China's high-profile jawboning could presage a release by the State Reserve Board (SRB) of some of its massive copper and aluminum stockpiles in the near term. In the case of copper, market guesses on the size of this stockpile are ~ 2mm to 2.7mm MT. On the aluminum side, Bloomberg reported CCP officials were considering the release of 500k MT to quell the market's demand for the metal. Chart of the WeekContinue Tightening In Copper Expected Continue Tightening In Copper Expected Continue Tightening In Copper Expected Chart 2Aluminum Remains Tight Aluminum Remains Tight Aluminum Remains Tight Brownfield Development Not Sufficient Our balances assessments continue to indicate key base metals markets are tight and will remain so over the short term (2-3 years). Economies ex-China are entering their post-COVID-19 recovery phase. This will be followed by higher demand from renewable generation and grid build-outs that will put them in direct competition with China for scarce metals supplies for decades to come. Markets will continue to tighten. In the bellwether copper market, we expect this tightness to remain a persistent feature of the market over the medium term – 3 to 5 years out – given the dearth of new supply coming to market. Copper prices are highly correlated with the other base metals (Chart 3) – the coefficient of correlation with the other base metals making up the LME's metals index is ~ 0.86 post-GFC – and provide a useful indicator of systematic trends in these markets. Chart 3Copper Correlation With LME Index Ex-Copper Less Metal, More Jawboning Less Metal, More Jawboning Copper ore quality has been falling for years, as miners focused on brownfield development to extend the life of mines (Chart 4). In Chart 5, we show the ratio of capex (in billion USD) to ore quality increases when capex growth is expanding faster than ore quality, and decreases when capex weakens and/or ore quality degradation is increasing. Chart 4Copper Capex, Ore Quality Declines Less Metal, More Jawboning Less Metal, More Jawboning Chart 5Capex-to-Ore-Quality Decline Set Market Up For Higher Prices Less Metal, More Jawboning Less Metal, More Jawboning Falling prices over the 2012-19 interval coincide with copper ore quality remaining on a downward trend, likely the result of previous higher prices that set off the capex boom pre-GFC. The lower prices favored brownfield over greenfield development. Goehring and Rozencwajg found in their analysis of 24 mines, about 80% of gross new reserves booked between 2001-2014 were due not to new mine discoveries but to companies reclassifying what was once considered to be waste-rock into minable reserves, lowering the cut-off grade for development.1 This is consistent with the most recent datapoints in Chart 5, due to falling ore grade values, as companies inject less capex into their operations and use it to expand on brownfield projects. Higher prices will be needed to incentivize more greenfield projects. A new report from S&P Global Market Intelligence shows copper reserves in the ground are falling along with new discoveries.2 According to the S&P analysts, copper demand is expected to exceed mined supply by 2028, which, in line with our view, sees refined-copper consumption exceeding production this year. Renewables Push At Risk Just last week, the IEA produced an ambitious and narrow path for governments to collectively reach a net-zero emissions (NZE) goal by 2050.3 Among its many recommendations, the IEA singled out the overhaul of the global electric grid, which will be required to accommodate the massive renewable-generation buildout the agency forecasts will be needed to achieve its NZE goals. The IEA forecasts annual investment in transmission and distribution grids will need to increase from $260 billion to $820 billion p.a. by 2030. This is easier said than done. Consider the build-out of China's grid, which is the largest grid in the world. To become carbon neutral by 2060, per its stated goals, investment in China’s grid and associated infrastructure is expected to approach ~ $900 billion, maybe more, over the next 5 years.4 The world’s largest fossil-fuel importer is looking to pivot away from coal and plans to more than double solar and wind power capacity to 1200 GW by 2030. Weening China off coal and rebuilding its grid to achieve these goals will be a herculean lift. It comes as no surprise that IEA member states have pushed back on the agency's NZE-by-2050 plan. This primarily is because of its requirement to completely halt fossil-fuel exploration and spending on new projects. Japan and Australia have pushed back against this plan, citing energy security concerns. Officials from both countries have stated that they will continue developing fossil fuel projects, as a back-up to renewables. Japan has been falling behind on renewable electricity generation (Chart 6). Expensive renewables and the unpopularity of nuclear fuel could make it harder for the world’s fifth largest fossil fuels consumer to move away from fossil fuels. Around the same time the IEA released its report, Australia committed $464 million to build a new gas-fired power station as a backup to renewables. Chart 6Japan Will Continue Building Fossil-Fuel Back-Up Generation Japan Will Continue Building Fossil-Fuel Back-Up Generation Japan Will Continue Building Fossil-Fuel Back-Up Generation Just days after the IEA report was published, the G7 nations agreed to stop overseas coal financing. This could have devastating effects for emerging and developing nations‘ electricity grids which are highly dependent on coal. In 2020 70% and 60% of India and China’s electricity respectively were produced by coal (Chart 7).5 Chart 7EM Economies Remain Reliant On Coal-Fired Generation Less Metal, More Jawboning Less Metal, More Jawboning Near-Term Copper Supply Risks Rise Even though inventories appear to be rebuilding, mounting political risks keep us bullish copper (Chart 8). Lawmakers in Chile and Peru are in the process of re-writing their constitutions to, among other things, raise royalties and taxes on mining activities in their respective countries. This could usher in higher taxes and royalties on mining for these metals producers, placing future capex at risk. In addition, Chile's state-owned Codelco, the largest copper producer in the world, fears a bill to limit mining near glaciers could put as much as 40% of its copper production at risk.6 None of these events is certain to occur. Peruvian elections, for one thing, are too close to call at this point, and Chile has a history of pro-business government. However, these are non-trivial odds – i.e., greater than Russian roulette odds of 1:6 – and if any or all of these outcomes are realized, higher costs in copper and lithium prices would result, and miners would have to pass those costs on to buyers. Bottom Line: We remain bullish base metals, especially copper. Another leg up in copper would pull base metals higher with it. We would look to get long on politically induced sell-offs, particularly with the USD weakening, as expected Chart 8Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y   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 Next Tuesday's OPEC 2.0 meeting appears to be a fairly staid affair, with little of the drama attending previous gatherings. Russian minister Novak observed the coalition would be jointly "calculating the balances" when it meets, taking into account the likely official return of Iran as an exporter, according to reuters.com. We expect a mid-year deal on allowing Iran to return to resume exports under the nuclear deal abrogated by the Trump administration in 2019, and reckon Iran has ~ 1.5mm b/d of production it can bring back on line, which likely would return its crude oil production to something above 3.8mm b/d by year-end. We are maintaining our forecast for Brent to average $64.45/bbl in 2H21; $75 and $78/bbl, in 2022 and 2023, respectively. By end 2023, prices trade to $80/bbl. Our forecast is premised on a wider global recovery going into 2H21, and continued production discipline from OPEC 2.0 (Chart 9). Base Metals: Bullish Our stop-losses was elected on our long Dec21 copper position on May 21, which means we closed the position with 48.2% return. The stop loss on our long 2022 vs short 2023 COMEX copper futures backwardation recommendation also was elected on May 20, leaving us with a return of 305%. We will be looking for an opportunity to re-establish these positions. Precious Metals: Bullish We expect the collapse in bitcoin prices, the US Fed’s decision to not raise interest rates, and a weakening US dollar to keep gold prices well bid (Chart 10). China’s ban on cryptocurrency services and Musk’s acknowledgment of the energy intensity of Bitcoin mining sent Bitcoin prices crashing. The Fed’s decision to keep interest rates constant, despite rising inflation and inflation expectations will reduce the opportunity cost of holding gold. According to our colleagues at USBS, the Fed will make its first interest rate hike only after the US economy has reached "maximum employment". The Job Openings and Labor Turnover Survey reported that job openings rose nearly 8% in March to 8.1 million jobs, however, overall hiring was little changed, rising by less than 4% to 6 million. As prices in the US rise and the dollar depreciates, gold will be favored as a store of value. On the back of these factors, we expect gold to hit $2,000/oz. Ags/Softs: Neutral Corn futures were trading close to 20% below recent highs earlier in the week at ~ $6.27/bu, on the back of much faster-than-expected plantings. Chart 9 Brent Prices Going Up Brent Prices Going Up Chart 10 US Dollar To Keep Gold Prices Well Bid US Dollar To Keep Gold Prices Well Bid     Footnotes 1     Please refer to Goehring & Rozencwajg’s Q1 2021 market commentary. 2     Please see Copper cupboard remains bare as discoveries dwindle — S&P study published by mining.com 20 May 2021. 3    Please see Net Zero by 2050 – A Roadmap for the Global Energy Sector, published by the IEA. 4    Please see China’s climate goal: Overhauling its electricity grid, published by Aljazeera.  5    We discuss this in detail in Surging Metals Prices And The Case For Carbon-Capture published 13 May 2021, and Renewables ESG Risks Grow With Demand, which was published 29 April 2021.  Both are available at ces.bcaresearch.com. 6    Please see A game of chicken is clouding tax debate in top copper nation, Fujimori looks to speed up projects to tap copper riches in Peru and Codelco says 40% of its copper output at risk if glacier bill passes published by mining.com 24, 23 and 20 May 2021, respectively.    Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights We update our assumptions for the likely 10-15 year return for a wide range of different asset classes. Our methodology is basically unchanged from our last Return Assumptions report published in 2019, though we have refined our analysis and use of data in some areas. Returns over the next decade will be very low compared to history. We project that a standard global portfolio (50% equities, 30% bonds, and 20% alternatives) will return only 3.0% a year in nominal terms. That compares to a historic return of 6.3%. There are still some assets that will produce better returns, most notably small caps (4.9% a year in the US) and alternatives (6.2% for private equity, for example). But they also carry higher risk. Spreadsheets are available with detailed data. Introduction This is the third edition of our work on return assumptions. Since publishing the previous reports in November 2017 and June 2019, we have had many opportunities to discuss our methodologies with clients and in the Global Asset Allocation course at the BCA Academy. This has allowed us to test and, in many cases, refine our approach. We believe the methodologies we use have stood the test of time. We have always emphasized that this sort of capital markets assumptions (CMA) analysis is an art, not a precise science. We continue to prefer to project returns over a somewhat undefined 10-15 year period, since this allows us to think about the underlying trend of likely returns. Many other CMA papers use five (or even three) year time horizons which, in our view, are problematical since they rely heavily on a forecast of the timing, length, and severity of the next recession. Our approach is based on the concept that the return on the risk-free long-term government bond is the cornerstone to projecting asset returns, and that this return is rather predictable: It is approximately the current yield. Most other asset returns can be built up from that – the return on high-yield bonds, for example, by assuming that their historic spread over government bonds, and default and recovery rates will continue in the future. For equities, we continue to use six different methodologies, which are based on a mixture of valuation and projected earnings growth. This approach – that assumed returns can be built up from a combination of current yield plus forecast future growth in capital values – also works for most alternative asset classes, for example real estate. We have made a few minor changes to our methodology in this edition. We have, for example, made our use of historical data (for spreads, profit margins, growth relative to GDP, etc.) more consistent, using the 20-year average where possible. The biggest change this time is that clients can download here a spreadsheet with all the data in this report in order, for example, to use the data as inputs into their own optimizers. In addition, we have set up our detailed spreadsheet to allow clients to see the underlying inputs, the formulae behind our methodologies, and to input their own assumptions. This will also allow us to update the results of our analysis as often as needed. Please let us know here if you would like more details about this additional service. This Special Report is structured as follows. First, we analyze the overall results: What is the probable return from each asset class over the next 10-15 years, and how do these differ from historical returns. Next, we describe in detail the methodologies we use, for (1) economic growth, (2) fixed-income instruments, (3) equities, and (4) 12 different alternative asset classes. Then, we describe our way of forecasting currency returns, and show the return assumptions in different base currencies. Finally, we update the numbers for volatility and correlations, which many investors need as inputs into optimization programs. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in US dollars). The data is updated to end-April 2021 (except for some alternative asset classes where only quarterly data is available). Table 1BCA Assumed Returns Return Assumptions 2021 Return Assumptions 2021 Overall Results Returns over the coming decade are likely to be very disappointing compared to history. Our assumptions suggest a typical global portfolio, consisting of 50% large-cap equities, 30% bonds, and 20% alternatives, will produce an annual nominal return of only 3.0%, compared to an average of 6.3% over the past 20 years. A US-only portfolio with a similar composition is likely to produce only a 3.1% return, compared to 7% in history. The reason is simple: Valuations currently are very stretched in almost every asset class. The risk-free rate (the 10-year government bond yield) in the US is 1.6% (compared to a 20-year average of 3.1%). It is negative in the euro area (in nominal terms) and zero in Japan. These rates are the anchor for the returns of all other asset classes, which are theoretically priced off the risk-free rate plus a risk premium. We have long argued that valuations are not a good timing tool for investors. An asset can remain very expensive or very cheap for a considerable period. But all the evidence shows that the valuation at the starting point is a very powerful indicator of long-run returns. The yield on government bonds, for example, has a strong correlation with their 10-year return (Chart 1). In the equity market, the Shiller PE has historically had little correlation with the return over one or two years, but has a 90% correlation with the return over the subsequent 10 years (Chart 2). Chart 1Starting Yield Determines Bond Returns Return Assumptions 2021 Return Assumptions 2021 Chart 2Valuation Drive Long-Run Equtiy Returns Valuation Drive Long-Run Equtiy Returns Valuation Drive Long-Run Equtiy Returns     With valuations in equity markets now expensive relative to history (for example, forward PE for US stocks of 22x compared to a 20-year average of 16x, and 18x in the euro zone compared to 13x), investors should expect that equity market returns will be low relative to history. Our assumptions point to a 2.6% annual return from US stocks, 2.3% from the euro zone, and 1.6% from Japan (compared to 8.5%, 3.9%, and 3.5% over the past 20 years). Our assumptions are significantly lower than when we last published our analysis in 2019; then we projected 5.6% for US stocks, 4.7% for the euro zone, and 6.2% for Japan. The difference is that equity multiples have risen and risk-free rates have fallen significantly since then. So what should investors do? They have only two choices: Lower their return assumptions, or increase their weightings in riskier asset classes. Chart 3Hard To See How US Pension Funds Will Achieve Their Targets Hard To See How US Pension Funds Will Achieve Their Targets Hard To See How US Pension Funds Will Achieve Their Targets The average US public pension fund (Chart 3) still assumes a return of 7% a year, and private pension funds’ assumption is not much lower. And yet corporate pension funds have been pushed by their consultants in recent years to increase their weighting in bonds, to more closely match their liabilities (Chart 4). It is almost mathematically impossible to achieve their targets with that sort of portfolio. In other countries, such as Australia or Canada, pension funds’ return targets are typically inflation or cash plus 3-4 percentage points. But even those targets are challenging.   Chart 4...Especially With Over 50% In Bonds Return Assumptions 2021 Return Assumptions 2021 There are asset classes which will produce higher returns. For example, we project a return of 4.9% from US small-cap stocks – and 9.7% from UK small caps. US high-yield bonds should produce a return of 3.2% a year (even after defaults) and Emerging Markets local currency sovereign debt 2.7% (in USD terms) – not exactly exciting, but at least a pick-up over other fixed-income securities. The projected returns from illiquid alternative assets continue to look relatively attractive. An equal-weighted portfolio of the 12 alternatives we cover is projected to return 5.7% a year, not much lower than the forecast of 6.1% from our 2019 report (and compared to an average of 7.1% of the past 20 years). There are some alt assets where returns have started to trend down: Private equity, for instance, is projected to return 6.2% a year, compared to 11.1% in history, and hedge funds 4.5%, compared to 5.9%. But the illiquidity premium should not disappear completely, even if the move of alternative investments to become more mainstream has reduced it to a degree. So adding more risky assets to a portfolio is an answer, at least for those investors with a long enough time-horizon that allows them to bear the inevitable big drawdowns that come with having a more volatile portfolio. And, unfortunately, lower returns mean that the incremental return gained for each unit of risk taken has declined compared to the past 10 or 20 years (Chart 5) – the efficient frontier has flattened significantly. Chart 5You Need To Take More Risk To Produce Return Return Assumptions 2021 Return Assumptions 2021 How We Came Up With The Assumptions GDP Growth Several of our methodologies use assumptions (for example, in equity methods (2) and (3), based on projections of earnings growth, real-estate capital-value growth, and commodities prices) which require estimates of nominal GDP growth in each country and region. To make these forecasts, we assume that nominal GDP growth can be decomposed into: (1) growth of the working-age population, (2) productivity growth, and (3) inflation. This ignores capital intensity, but it has been relatively stable over history and is difficult to forecast. Table 2 shows the assumptions we use, and our forecasts for real and nominal GDP in each country and region. Table 2Calculations Of Trend GDP Growth Return Assumptions 2021 Return Assumptions 2021 For population growth we use the United Nations’ median forecast of annual growth in the population aged 25-54 between 2020 and 2040. This ranges from -1% in Japan to +1% in Emerging Markets – although note that the range of forecast population growth in EM varies widely from 1.2% in India to -1.1% in Korea (and in China, too, is negative at -0.7%). This estimate is reasonably reliable, although it does miss some possible factors, such as changes in the female participation rate, hours worked, and changing openness to immigration. Productivity is much harder to forecast. Over the past 10 to 20 years, productivity growth has trended down in most countries (Charts 6A & B). We take a slightly more optimistic view, assuming that productivity growth over the next 10-15 years will equal the 20-year average. We base this on the belief that part of the decline in productivity since the Global Financial Crisis is due to cyclical reasons which are now dissipating, and also to expectations that new technologies coming through (artificial intelligence, big data, automation, robotics etc) will boost productivity in the coming years. Others take a more pessimistic view. The Congressional Budget Office’s forecast of trend real US GDP growth in 2022-2031 of 1.8%, for example, is lower than our estimate of 2.2% mainly because of its more cautious estimate of productivity growth. Chart 6AProductivity Growth (I) Productivity Growth (I) Productivity Growth (I) Chart 6BProductivity Growth (II) Productivity Growth (II) Productivity Growth (II)   To derive nominal GDP growth, we assume that inflation over the next 10 years will be on average the same as over the past 20 years, for example 2% in the US, 1.6% in the euro area, 0.1% in Japan, and 3.9% in Emerging Markets (using a weighted average of EM by equity market cap). This estimate, too, has a high degree of uncertainty. One could imagine a scenario whereby inflation picks up significantly over the next decade due to excessively easy monetary policy, overly generous fiscal spending, growth in protectionism, rising labor pressure for wage increases, and the effects of a rising dependency ratio (the ratio of non-working people, especially retirees, to total population).1 But another scenario of continued “secular stagnation” and disinflation, caused by automation-driven job losses and a chronic lack of aggregate demand, is also conceivable. We think our middle-path forecast is the most sensible one to use in projecting likely asset returns, but investors might also want to plan based on these alternative scenarios too. Note that for Emerging Markets, we continue to show two different scenarios, which vary according to different projections of productivity growth. EM productivity growth has been declining steadily since around 2010, and in all major emerging economies, not just China. Our first scenario assumes that this decline ends and that, as in our assumption for developed economies, productivity growth reverts to the 20-year average. The more pessimistic (and, in our view, more likely) scenario assumes that the deterioration in productivity continues and that in 10 years’ time, EM productivity is the same as the average of developed economies. Which scenario will be correct depends on whether emerging economies, not least China, are able to implement structural reforms over the next decade, for example liberalizing the labor market, allowing a greater role for the private sector, improving corporate governance, and institutionalizing more orthodox fiscal and particularly monetary policy. Fixed Income Our anchor for calculating assumed returns is the return on long-term risk-free assets, specifically the 10-year government bond in the strongest countries. It is a reasonable assumption that an investor who buys, for example, a 10-year Treasury bond today and holds it for 10 years will make 1.6% a year in nominal US dollar terms. While this is not perfectly mathematically correct (since it ignores reinvested interest payments, for instance), empirically the return on government bonds has been very closely linked to the yield at the start-point in history (see Chart 1). From this starting-point in each country, we can easily build up the return for other fixed-income assets. These assumptions and the results are shown in Table 3. Table 3Fixed-Income Return Calculations Return Assumptions 2021 Return Assumptions 2021 Government bonds in most countries have an average duration of less than 10 years. Over the past five years, in the US it has averaged 6.4 years, and in the euro area 8.0 years. Only in the UK is the average over 10 years: 12.4 years to be precise. To calculate the return from the government bond index for each country we therefore assume that the shape of the yield curve (using the spread between 7-year and 10-year bonds) in future will be the same as the historic 20-year average. Cash. We assume that over the next 10 years the yield on cash will gradually revert to an equilibrium level. We calculate a market-implied real long-term neutral rate from the 10-year historical average of 5-year/5-year OIS implied forwards deflated by the 5-year/5-year implied CPI swap rate. This is a change from the methodology we used in 2019, when we based this off the neutral rate, r*, as calculated by the Holston Laubach-Williams model. But the New York Fed has temporarily stopped updating its calculation of this due to pandemic-induced volatility in the data, and anyway it was not available for every country. We turn the real cash rate into a total nominal return using our assumption for inflation described in detail in the GDP section above, the 20-year historical average of CPI. For inflation-linked securities, such as TIPS, we take the average yield over the past 10 years (a 20-year average was not available in many markets) and add the assumption for inflation described above. Corporate credit. We assume that spreads, and default and recovery rates, while highly volatile over the cycle, remain stable in the long run (Chart 7). We use 20-year averages for these, except that data for investment-grade default rates in Japan, the UK, Canada, and Australia are not available and so we use the average of the US and the euro zone. High-yield default rates are not available for the UK either, and so we do the same. Other bonds. For government-related debt (which is a big part of some bond indexes, 28% in the US for example) we assume that the 20-year historical average of the option-adjusted spread over government bonds will apply in the future too. We use the same methodology for securitized debt (for example, mortgage- and asset-based bonds): The 20-year average spread over the return on government bonds. Emerging Market debt. The assumptions and results for the three categories of EM debt (US dollar sovereign debt, US dollar corporate debt, and local currency sovereign debt) are shown in Table 4. We here assume that the 20-year average historical spread will continue in future. Default and recovery rates are a little harder to calculate, due to a lack of data. For USD sovereign debt (where defaults are rare and so hard to project), we use the rating-based default rate, calculated by Aswath Damodaran of NYU Stern School of Business.2 For USD-denominated EM corporate debt, we use the historical average, calculated by Moody's 2.5%.3 For local-currency debt, we use the same rating-based default rate as for USD sovereign debt. To translate the return into hard currency, we assume that currencies will move in line with the inflation differential between Emerging Markets and the US. For EM inflation we use an average of the IMF’s inflation forecasts for the nine largest emerging markets weighted by their weights in the J.P. Morgan GBI-EM Global Diversified local government bond index, and compare this to our US inflation forecast. This produces an EM inflation forecast of 2.9% a year, compared to 2.2% for the US, thus lowering the USD-based return from local EM debt by 0.7 percentage point. (See a more detailed discussion of forecasting long-term EM currency changes in the Currency section below). Index returns. Table 3 also shows the assumed return for the Bloomberg Barclays bond index for each country and for the global bond index, based on a weighted average of our assumption for each fixed-income asset class and country. Chart 7ACredit Spreads & Default Rates (I) Credit Spreads & Default Rates Credit Spreads & Default Rates Chart 7BCredit Spreads & Default Rates (II) Credit Spreads & Default Rates Credit Spreads & Default Rates   Table 4Emerging Market Debt Return Assumptions 2021 Return Assumptions 2021   Equities The assumptions and detailed results for seven different equity markets are shown in Table 5. We have not made any substantial changes to our methodology for equities. We continue to use the average of six different methods to calculate the probable equity returns over the next 10-15 years. These are: Equity Risk Premium (ERP). The return from equities equals the yield on government bonds (we use 10-year bonds) plus an equity risk premium. For the US, we use an equity risk premium of 3.5%. This is based on work by Dimson, Marsh and Staunton4 showing that this is approximately the average excess return of equities over bonds in developed economies since 1900. We scale the equity risk premium for other countries using their average beta to the US market over the past 10 years. This varies from 0.66 for Japan (giving an ERP of 2.3%) and 1.2 in the euro area (ERP is 4.2%). Growth model. Here we assume that the return from equities equals the current dividend yield plus dividend growth. We need to adjust the dividend yield, however, to take into account that in some countries, particularly the US, it is more tax efficient for companies to do buybacks than to pay out dividends. We do this by adding equity withdrawals to the dividend yield. But this needs to be done on a net basis (taking into account equity issuance). We calculate this using the average annual change in the index divisor over the past 10 years. For the US, this is -0.8%, meaning there are more buybacks than new share issues. But in all other regions, the number is positive, and as high as 5.9% a year for Emerging Markets. This dilution is something that many calculations of assumed equity returns miss. For dividend growth, we assume that the dividend payout ratio remains stable, and that earnings growth is correlated with nominal GDP growth. However, history shows that earnings grow more slowly than GDP (logically so, when you consider that companies usually grow fastest before they list on a stock exchange). So we deduct 1% from nominal GDP growth to derive our earnings growth assumption. Note that for Emerging Markets, we use two different measures of dividend growth, depending on future productivity growth, as detailed above in our explanation of the GDP projections. Growth model (with reversion to mean). To take into account that valuations and profit margins typically revert to mean over the long run, we adjust the standard growth model (No. 2 above) by assuming that the current 12-month forward PE ratio and forward net profit margin for each country gradually revert over the next 10 years to their 20-year average. In the US, for example, that would mean that the current 12-month forward PE of 22.5x falls back to 16.0x, and profit margin of 12.5% falls to 10.7%. In every country and region, the profit margin is currently above the long-run average, and in all except the UK the PE is too. Note that we have changed from using the trailing PE and margin, because to use these now would be misleading given the big pandemic-driven decline in profits in 2020. Earnings yield. An intrinsically intuitive (and empirically demonstrable) way of estimating future returns is to use the earnings yield. This is based on the idea that an investor’s return from owning a stock comes either from the company paying a dividend, or from it investing retained earnings and paying a dividend in future. In the US, for example, a forward PE of 22.5x translates into an earnings yield of 4.4%. Again, here we switched this time to using 12-month forward forecast earnings yield, rather the trailing. Shiller PE. There is a strong correlation between valuation at the starting-point and the subsequent return from equities, at least over the long-run, although not over a period of less than 3-5 years (Chart 2). We regressed the Shiller PE (current price divided by average real earnings over the past 10 years) against the return from equities over the subsequent 10 years for each country and region. Composite valuation metric. The Shiller PE has its detractors. Using a fixed 10-year period does not reflect the different lengths of recessions and bull markets. It may say more about the mean-reverting nature of earnings than about whether the current price level is too high. So we also use the BCA Compositive Valuation Metric, which comprises eight indicators including, besides standard valuation measures such as price/sales and price/book, more esoteric ones such as market cap/GDP and Tobin’s Q. Again, we regress the metric against the subsequent 10-year return. Table 5Equity Return Calculations Return Assumptions 2021 Return Assumptions 2021 Alternative Assets Real Estate & REITs. We use the same basic methodology for both: The current yield (cap rate or dividend yield) plus projected capital value appreciation (linked to GDP growth). For US direct real estate, for example, we use the simple average cap rate of the five categories of commercial real estate (CRE), apartments, office, retail, industrial, and hotels in major cities: 6.1%. We also use the simple average of available city and category data for other countries. Cap rates are notoriously hard to estimate precisely; our data include a range of real estate, not just prime locations. We assume that capital values will grow in line with nominal GDP growth (using the same assumptions for this as we used for equities, 4.2%). We then deduct 0.5% for maintenance. This produces an expected return of 9.8% for the US. The only difference for REITs is that we do not deduct maintenance since this should already be reflected in the dividend yield. US REITs have a dividend yield currently of 3.5%, which produces an assumed return of 7.7% (Table 6). One risk with this methodology is that in the post-pandemic world, work and life practices might change. This will hurt office and residential real estate in major cities (which are overrepresented in investible CRE), though smaller cities and rural areas might benefit. As a result, capital values might fall. Table 6Alternatives Return Calculations Return Assumptions 2021 Return Assumptions 2021 Farmland & Timberland. Our methodology is similar to that for real estate: Current yield plus projected growth in capital values. For farmland, we use the farmland renter yield, sourced from the US Department of Agriculture. To estimate future land values, we take the gap between land value growth over the past 40 years (3.7%) and nominal growth of world GDP over that time (5.2%), assume that gap will continue and so deduct it from our estimate of global nominal GDP growth going forward (3.6%). This gives a result of 6.5%. For timberland, we assume that annualized returns in the future are the same as over the past 20 years. This produces a return assumption of 5.7%, which is (logically) moderately lower than our assumed return for farmland. Private Equity & Venture Capital. We project the return for private equity (PE) using the 30-year time-weighted average of the three-year rolling annualized return of PE over US large-cap equities, 3.6% (Chart 8). This produces an assumed return of 6.2%. For venture capital (VC), we use the same historical average for VC over PE (0.4%) to arrive at an assumed return of 6.6%. Hedge Funds. We use the 20-year time-weighted return of the Hedge Fund Composite Index over cash, 3.5% (Chart 9). This projects a future annual nominal return of 4.5%. Commodities. We previously used a methodology based on the idea that commodities’ bear markets in history have been rather fairly consistent, lasting on average 17 years, with an average decline of 50%, and that the current bear market began in 2012 (Chart 10). However, there are arguments that a new “commodities super-cycle” may be starting, driven by government infrastructure spending, and investment in alternative energy.5 We are agnostic for now on whether that will be the case, but it makes sense to switch to a neutral methodology, more in line with what we use for other assets classes: The return from commodities relative to GDP over the long run. Specifically, the CRB Raw Industrials Index has risen by an annualized 1.6% since 1951, during which time US nominal GDP growth averaged 6% (Chart 11). We assume that the differential will continue in future (although we calculate growth using global, not US, GDP), giving an annual return from commodities over the next 10-15 years of -0.9%. Gold. We calculate this using a regression of the gold price against nominal GDP growth and the annual change in the real 10-year yield over the past 40 years. For the forward-looking return assumption, we use a forecast of real rates (based on the equilibrium cash rate plus the average historical spread between the 10-year yield and cash) and a forecast of global nominal GDP growth. This produces an assumed return of 3.8%. Structured products. This asset class consists mainly of mortgage-backed and other asset-backed securitized instruments. In the US, these have historically returned 0.6% over US Treasurys. We assume that this premium continues, producing a total future return of 1.1% a year. Chart 8Private Equity Premium Private Equity Premium Private Equity Premium Chart 9Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge Fund Return Over Cash     Chart 10Commodity Prices In History Commodity Prices In History Commodity Prices In History Chart 11Commodity Prices Vs. GDP Growth Commodity Prices Vs. GDP Growth Commodity Prices Vs. GDP Growth     Currencies Chart 12Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP To translate our local currency returns into an investor’s base currency, we need to arrive at some projections for FX movements over the next decade. Fortunately, for developed market currencies at least, it is relatively straightforward to use purchasing power parities (PPP) to do this since, over the long run, all the major currencies have tended to revert to PPP (Chart 12). We assume that in 10 years’ time all currencies will trade at PPP. We use the IMF’s estimate of today’s PPP for each currency to calculate the current under- or over-valuation. We assume that PPP will change in future years according to the relative inflation between each country and the US. The IMF provides five-year inflation forecasts and we assume that inflation will continue at this rate until 2031. For the euro zone, we calculate the PPP of the euro using the GDP-weighted PPPs of the five largest economies. The results (Table 7) suggest that the US dollar is currently overvalued and, given the forecast of higher inflation in the US than elsewhere in the future, will depreciate significantly against all major currencies except the Australian dollar. The USD is projected to depreciate by 1.7% a year against the euro and 1.1% against the yen over the next 10 years. It is likely to appreciate by 1.3% a year against the AUD, however. Table 7Currency Return Calculations Return Assumptions 2021 Return Assumptions 2021 Emerging Markets (Table 8) are more complicated. There is no evidence that EM currencies move towards PPP over time. All the major EM currencies are currently very cheap versus PPP (varying from 34% undervalued for the Chinese yuan to 67% for the Indonesian rupiah) but they were 10 years ago, too, and have not significantly moved towards PPP over that time. Table 8EM Currencies Return Assumptions 2021 Return Assumptions 2021 To calculate likely EM currency moves against the USD, therefore, we carry out a regression of the nine largest EM currencies against their relative CPI inflation rate to US inflation in history. We assume an intercept of zero. The regression coefficients vary from +0.5 for China to -1.7 for Malaysia. Apart from China, Malaysia, Poland and South Africa, the coefficients were negative, meaning that historically the USD has strengthened against the EM currency at least partly in line with relative inflation. To calculate likely future currency movements, we use the IMF’s five-year inflation forecasts and assume that the same rate of inflation will continue for our whole projection period. This methodology points to moderate annual depreciation of most EM currencies against the USD, varying from 0.8% a year for the Russian ruble to 0.1% for the Indonesia rupiah. The Chinese yuan and Taiwanese dollar are projected to appreciate moderately. We calculate the average EM currency movement using the weights of these nine large economies in the EM J.P. Morgan GBI-EM Global Diversified local-currency sovereign bond index. This produces a small (0.1%) a year appreciation. However, the IMF’s EM inflation forecasts may be too optimistic. It forecasts, for example, that Brazilian inflation will be only 3.3% a year in future, compared to an average of 6.1% over the past 20 years, and Russian inflation 4.0% versus a historical average of 9.3%. This suggests that EM currency performance could be worse than our projections. Table 9 shows the returns for the major asset classes expressed in local currency terms for six base currencies, based on the calculations explained above. Table 9Returns In Different Base Currencies Return Assumptions 2021 Return Assumptions 2021 Correlation And Volatility Below, in Table 10, we provide correlations for clients who need these inputs for their optimization calculations. Table 10Long-Run Correlation Matrix Return Assumptions 2021 Return Assumptions 2021 Returns can be calculated using the sort of forward-looking methodologies we have described above. For volatility, we think it is reasonable to use historical average data (Table 1, far right column), since volatility does not tend to trend over the long run (Chart 13). But correlation is a different matter. Correlations have varied significantly in history due to structural changes or regime shifts. The correlation of equities to bonds, it is well known, has moved from positive in the 1980s and 1990s, to negative since 2000 – probably because inflation disappeared as a factor moving bond prices (Chart 14). The correlation between equity market has risen as a result of the globalization of investment flows, though note that it fell back in 2010-2019. Chart 13Volatility Is Fairly Stable In The Long Run Volatility Is Fairly Stable In The Long Run Volatility Is Fairly Stable In The Long Run Chart 14Correlations Are Not Stable Correlations Are Not Stable Correlations Are Not Stable   So what correlations should investors use in an optimizer? Our recommendation would be to use the longest period of history available. A US investor, for example, might take the average correlation between Treasury bonds and large-cap US equities since 1945, 0.1%. Table 10 shows the correlation since 1973 of all the major asset classes for which data is available. Unfortunately, this misses some important asset classes such as high-yield bonds and Emerging Market equities, whose history does not go back that far. The results are intuitive – and prudent. From these numbers, it would seem sensible to use an assumption of a small positive correlation between US Treasurys and US equities, for example. US investment-grade debt has a correlation of 0.4 against equities. Global equity markets are all fairly highly correlated to each other, ranging mostly from 0.4 to 0.7. The most non-correlated asset class is commodities, especially gold.   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com   Footnotes 1 These are themes that BCA Research has been writing about for several years. See, for example, please see Global Investment Strategy, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; and " 1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. 2 Please see http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html 3 Annual Emerging Markets Default Study: Coronavirus Will Push Up Default Rates https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1214906 4 Please see, for example, https://www.credit-suisse.com/media/assets/corporate/docs/about-us/research/publications/credit-suisse-global-investment-returns-yearbook-2021-summary-edition.pdf. 5 Please see Commodity & Energy Strategy, "Industrial Commodities Super-Cycle Or Bull Market?", dated March 4, 2021.

Dear client, In addition to this weekly report, we also sent you a Special Report on cryptocurrencies, authored by my colleagues Guy Russell and Matt Gertken. The conclusion is that government authorities are likely to lean against the proliferation of cryptocurrencies, something we suspected in our most recent report on the topic. Regards, Chester Highlights Net foreign inflows into US assets probably peaked in March. Meanwhile, there are strong reasons to believe outflows from US securities will accelerate in the coming months. As such, the 12-18-month outlook for the US dollar remains negative. Cryptocurrencies are correcting sharply amidst a crackdown in China, a risk we warned investors about in our Special Report last month. We are increasingly favoring the yen. Lower the limit-sell on USD/JPY to 109. Hold long CHF/NZD positions recommended last week. Feature Chart I-1Current Account Deficit = Capital Account Surplus Current Account Deficit = Capital Account Surplus Current Account Deficit = Capital Account Surplus The US runs a sizeable trade deficit. As such, it must import capital to finance this deficit (Chart I-1). Over the last year, this has been driven by equity and agency bond purchases by foreigners. However, we might be at the apex of a shift, where foreign appetite for US securities starts a meaningful decline. Financing The US Deficit TIC data is usually a lagging indicator for FX markets, but still holds valuable insights into foreign appetite for US assets. On this front, the March data was particularly instructive: There were strong inflows into US Treasury notes and bonds, to the tune of almost $120 bn. This was the greatest driver of monthly inflows. This was also the largest monthly increase since the global financial crisis. Net inflows into US equities stood at $32.2 bn in March. This is on par with the three-month average, but a sharp deceleration from December inflows of $78.3 bn. Corporate bonds commanded particularly strong inflows in March to the tune of $43.1 bn. It appears that foreign private concerns swapped their agency bond purchases with corporate bonds. US residents repatriated $54.1 bn back home in March. Official concerns were big buyers of long-term US Treasury bonds, but this was offset by a large sale of US T-bills. Net foreign official purchases of overall US securities were just $6.5 bn. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. The question going forward is whether there has been a regime shift in US purchases, specifically the purchase of equities (and agency bonds). And if so, can the purchase of US Treasurys pick up the slack (Chart I-2). Foreign inflows into the US equity market tend to be driven by expected rates of return, either from an expected rerating of the multiple or from profit growth. A rerating of the US equity multiple, relative to the rest of the world, has inversely tracked interest rates (Chart I-3). This is due to the higher weighting of defensive sectors in the US equity market. Concurrently, we showed in a recent report that profit growth on an aggregate level also tends to move in sync with relative economic momentum.1  Chart I-2Equity Inflows Have Financed ##br##The US Deficit Equity Inflows Have Financed The US Deficit Equity Inflows Have Financed The US Deficit Chart I-3Rising Bond Yields Would Curtail Equity Inflows Rising Bond Yields Would Curtail Equity Inflows Rising Bond Yields Would Curtail Equity Inflows If growth is rotating away from the US, and global bond yields still have upside, this will curtail foreign appetite for US equities. This appears to be the story since March, as non-US bourses have outperformed (Chart I-4). Chart I-4ANon-US Markets Are Bottoming Non-US Markets Are Bottoming Non-US Markets Are Bottoming Chart I-4BNon-US Markets Are Bottoming Non-US Markets Are Bottoming Non-US Markets Are Bottoming In terms of fixed income flows, the rise in US bond yields towards a peak of circa 180bps in March undoubtedly triggered strong inflows into the US Treasury market. Since then, yields outside the US have been moving somewhat higher, especially in Germany. This should curtail bond inflows, and also fits with a growth rotation away from the US. While foreign central banks were net buyers of US Treasurys in March, the “other reportables” category from the CFTC data show a huge short position in US 10-year futures. Foreign central banks are usually grouped in this category. This will suggest the accumulation of Treasurys should reverse in the coming months (Chart I-5). Chart I-5Did Central Banks Hedge Their March Purchases? Did Central Banks Hedge Their March Purchases? Did Central Banks Hedge Their March Purchases? A rotation of growth from the US towards other parts of the world would also make it more difficult to finance the US current account deficit. This is because it will compress real interest rate spreads between the US and the rest of the world. From a historical perspective, inflows into US Treasury assets only tend to accelerate when real rates in the US are at least 50-100 bps above that in other G10 economies (Chart I-6). That could explain why despite a positive Treasury-JGB spread of 165 basis points, Japanese investors were very much absent buyers in March (Chart I-7). Chart I-6Real Rate Differentials And Bond Capital Flows Real Rate Differentials And Bond Capital Flows Real Rate Differentials And Bond Capital Flows Chart I-7The Big Boys Did Not Buy Much Treasurys In March The Big Boys Did Not Buy Much Treasurys In March The Big Boys Did Not Buy Much Treasurys In March Critical to this view is the outlook for US inflation. On this front, we note the following: First, the output gap in the US should close faster than most other economies, at least according to the OECD (Chart I-8). Ceteris paribus, US inflation should outpace that in other countries in the near term and put downward pressure on real rates. Chart I-8The US Should Generate Higher Inflation The US Should Generate Higher Inflation The US Should Generate Higher Inflation Fiscal spending has been more pronounced in the US compared to other countries, which will further fan the inflationary flames. The Fed is the only central bank in the G10 committed to an inflation overshoot. In a nutshell, there is compelling evidence to suggest US inflows peaked in March from both foreign equity and bond investors. Upside surprises in inflation are more likely in the US in the very near term compared to other economies, which will depress real rates. Meanwhile, higher global yields are also a negative for the US equity market. There Is No Alternative Chart I-9A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys My colleague, Mathieu Savary, has made the case that there is no alternative to US Treasurys. The treasury market is the most liquid and the deepest safe haven pool in the capital market universe (Chart I-9). Ergo, a flight to safety will always bid up Treasurys, as we saw in March 2020. We do agree that Treasurys will continue to act as the world’s safe haven benchmark for now. However, that privilege is fraying at the edges, and it is the marginal changes that matter for dollar investors. Competition for safe haven assets continues to intensify as the narrative switches from 40 years of disinflationary forces to the rising prospect of an inflation overshoot. Inflation is anathema to fiat currencies, including the dollar. For investors, precious metals have been a preferred habitat for anti-fiat holdings. That said, cryptocurrencies are also rising in the ranks as an alternative. In our Special Report2 released a month ago, we suggested government regulation was a huge risk for cryptocurrencies. But more specifically, the degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Since the peak in the DXY index in 2020, the biggest sellers of US Treasurys have been private investors. Cryptocurrencies benefited from this diversification. That has changed since March, which partly explains the big drawdown in crypto prices. In general, you always want to align yourself with strong buyers who are price indiscriminate. Foreign central banks (the biggest holders of US Treasurys) prefer gold as their anti-dollar asset. This puts an solid footing under gold prices, compared to cryptocurrencies or other anti-fiat assets. It is worth noting that competition between the dollar and gold often run in long cycles. In the 1970s, as inflation took hold in the US, the dollar depreciated and gold soared. In the 1980s, the dollar took off and gold fell sharply, as the Federal Reserve was able to bring down inflation. The 1990s were relatively disinflationary, which supported the dollar (Chart I-10). A whiff of rising inflation in the early 2000s hurt the dollar, while the 2010s were characterized by very low inflation, supporting the dollar. More recently, the dollar is weakening as inflationary trends accelerate faster in the US (Chart I-11). Chart I-10The Dollar And Inflation Move Opposite Ways (1) The Dollar And Inflation Move Opposite Ways (1) The Dollar And Inflation Move Opposite Ways (1) Chart I-11The Dollar And Inflation Move Opposite Ways (2) The Dollar And Inflation Move Opposite Ways (2) The Dollar And Inflation Move Opposite Ways (2) One of our favorite indicators for gauging ultimate downside in the dollar is the bond-to-gold ratio. The rationale is that the bond-to-gold ratio should capture investor preference at the margin for either US Treasurys or gold. This in turn has been a good measure of investor confidence in the greenback. On this basis, the bond-to-gold ratio (TLT-to-GLD ETF) is breaking down to fresh cycle lows (Chart I-12). This has historically pointed towards a lower US dollar. Chart I-12The Dollar And The Bond-To-Gold Ratio The Dollar And The Bond-To-Gold Ratio The Dollar And The Bond-To-Gold Ratio Within precious metals, we like gold but love silver. As such, we are short the gold-to-silver ratio since an entry point of 68. Our bias is that initial support for this ratio is 60. Meanwhile, we also like platinum, and will go long versus palladium at current levels. A Few Other Indicators A few other market developments are pointing to a lower dollar in the coming months. The dollar tends to decline in the second half of the year. This has been true since the 1970s (Chart I-13). Importantly, even during the Paul Volcker years in the 80s when the dollar staged a meaningful rally, it often fell in the second half of the year. The winner in the second half of the year has usually been the Swiss franc and the Japanese yen (Chart I-14).  Chart I-13The Dollar Usually Strengthens In H1 A Peak In US Inflows? A Peak In US Inflows? Chart I-14The Dollar Usually Weakens In H2 A Peak In US Inflows? A Peak In US Inflows? The OECD leading economic indicators still suggest US growth remains robust relative to the rest of the G10. However, our expectation is that this gap will decrease sharply in the second half of this year. That said, the current reading is a risk to our dollar bearish view (Chart I-15). Chart I-15US Exceptionalism Is A Risk For Dollar Bears US Exceptionalism Is A Risk For Dollar Bears US Exceptionalism Is A Risk For Dollar Bears Lumber has started to underperform Dr. Copper. Lumber benefits from solid US housing activity, while copper is more tied to global growth and the emerging investment in green technology. As a counter-cyclical currency, the dollar also tends to underperform higher beta currencies when lumber is underperforming copper (Chart I-16). The copper-to-gold ratio has also bottomed, suggesting ample liquidity is now fueling growth (Chart I-17). We suggested last week that the velocity of money across countries was a key variable to watch in getting the dollar call right. So far, the collapse in money velocity is least acute in China, explaining the rise in the copper-to-gold ratio and the improvement in non-US yields compared to the US. Chart I-16Lumber/Copper Prices And The Dollar Lumber/Copper Prices And The Dollar Lumber/Copper Prices And The Dollar Chart I-17Copper/Gold Prices And Bond Yields Copper/Gold Prices And Bond Yields Copper/Gold Prices And Bond Yields In summary, many cyclical indicators still point to a lower dollar. The key risk to this view is an equity market correction, and/or persistent relative strength in US growth.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Report, "Trading Currencies Using Equity Signals," dated May 7, 2021. 2 Please see Foreign Exchange Special Report, "Will Cryptocurrencies Displace Fiat," dated April 23, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The selloff in crypto-currencies on May 19 may be overblown but the risk of government intervention is a rising headwind for this asset class. While environmental concerns are a threat to Bitcoin, the entire crypto-currency complex faces a looming confrontation over governance. Digital currencies are a natural evolution of money following coinage and paper. Moreover a sizable body of consumers is skeptical of governments and traditional banking. Loose monetary conditions are fueling a speculative mania. However, governments fought for centuries to gain a monopoly over money. As crypto-currencies become more popular, governments will step in to regulate and restrict them. Central bank digital currencies (CBDCs) threaten to remove the speed and transactional advantage of crypto-currencies, leaving privacy/anonymity as their main use-case. Feature The prefix “crypto” derives from the Greek kruptos or “hidden.” This etymology highlights one of the biggest problems confronting the crypto-currency craze in financial markets today. Speed and anonymity are the greatest assets of the digital tokens. But the former advantage is being eroded by competitors while the latter is becoming a political liability. In the 2020s, governments are growing stronger and more interventionist, not weaker and more laissez faire. Chart 1Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Bitcoin and rival crypto-currency Ethereum fell by 29.5% and 43.2% in intra-day trading on May 19, only to finish the day down by 13.8% and 27.2%, respectively. The market panicked on news that China’s central bank had banned firms from handling transactions in crypto-currencies. What really happened was that China’s National Internet Finance Association, China Banking Association, and Payment and Clearing Association issued a statement merely reiterating a 2013 and 2017 policy that already banned firms from handling transactions in crypto-currencies. These three institutions also warned about financial speculation regarding crypto-currencies.1 The crypto market suffered a spike in volatility because it is in the midst of a speculative mania. In the last five years, total market capitalization of crypto-currencies has risen from around $7 billion to $2.3 trillion,2 recording a 34,000% gain. Some crypto-currencies have even recorded returns in excess of that number over a shorter horizon. Price gains have been driven by retail buyers who may or may not know much about this new asset class (Chart 1). Prior to the May 19 selloff, prices had grown overextended and recent concerns over the environment, sustainability, and governance (ESG) had shaken confidence in Bitcoin and its peers. Chinese authorities have already banned financial firms from providing crypto services in a bid to deter ownership of crypto-currencies. And China is not alone. The latest market jitters are a warning sign that government interference in the crypto-currency market is a real threat. Regulation and sovereign-issued digital currencies are starting to enter the fray. While ultra-dovish central bank policies are not changing soon, and therefore crypto-currency price bubbles can continue to grow, crypto-currencies will remain subject to extreme volatility and precipitous crashes. In this report we argue that the fundamental problem with crypto-currencies is that they threaten the economic sovereignty of nation-states. Environmental degradation, financial instability, and black market crime, and other concerns about cryptos have varying degrees of merit. But they provide governments with ample motivation to pursue a much deeper interest in regulating a technological innovation that has the power to undermine state influence over the economy and society. Government scrutiny is a legitimate reason for crypto buyers to turn sellers. Does The World Need Crypto-Currencies? Broadly speaking, there are two primary justifications for crypto-currencies, centered on a transactional basis: speed and privacy/anonymity. The crux of crypto-currency creation rests on these two use cases.3 The speed of crypto-currencies comes from their ability to increase efficiency in local and global payment systems by facilitating financial transactions without the need of a third party (e.g. a financial institution). Cross-border settlement of traditional (fiat) currency transactions processed through the standard SWIFT communications system takes up to two business days. Most transactions involving crypto-currencies over a blockchain network are realized in less than an hour, cross-border or not.4 The fees involved with third-party payments are often more expensive than transacting with crypto-currencies. Simply put, excluding the “middleman” can save money. This is a selling point in a global market that expects to see retail cross-border transactions reach $3.5 trillion by the end of 2021, of which up to 5% are associated with transaction-based fees.5 But this breakthrough in payment system technology can be overstated and is not the main reason for using crypto-currency. Speculation drives current use, especially given that there is speculative behavior even among those who believe that cryptos are safe-haven assets or promising long-term investments (Chart 2). Chart 2Crypto-Currency Use Driven By Speculation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 3Consumers Growing Skeptical Of Banking Regulation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide If a person wants to buy an item from a company in a distant country, that person could use a crypto-currency just as he or she could use a credit card. Both parties would have a secure medium of exchange but, unlike with a credit card, both would avoid using fiat currencies. Neither party could conduct the same transaction using gold or silver. The crucial premise is the existence of an online community of individuals and firms who for one reason or another want to avoid fiat currencies. From a descriptive point of view, the crypto-currency phenomenon implies a lack of trust in modern governments, or at least their monetary systems, and an assertion of individual property rights. The list of crypto-currencies continues to grow. To date, there are approximately 9,800 of them. Some are trying to prove their economic value or use, while others have been created with no intended purpose or problem to solve. Even so, there has yet to be a crypto-currency that overwhelms the use of slower fiat money. In a recent Special Report, BCA Research’s Foreign Exchange Strategist Chester Ntonifor showed that crypto-currencies still have a long way to go to have a chance at replacing fiat monies. While crypto-currencies are showing signs of significant improvement as mediums of exchange, they still fall short as stores of value and units of account. The other primary case for crypto-currencies is privacy or anonymity. The bypassing of intermediaries implies a greater control of funds by the two parties of a transaction. Crypto-currencies are said to be more “private” compared to fiat money. Fiat money is controlled by governments and banks while crypto-currencies have only “owners.” Crypto-currencies are anonymous because they are stored in digital wallets with alphanumeric sequences – there is a limited personal data trail that follows crypto-currency compared to those of electronic fiat currency transactions. In a post-9/11, post-GFC, post-COVID world where a sizable body of consumers is growing more skeptical of government surveillance and regulation and banking industry practices (Chart 3), crypto-currencies give users more than just a means to transact with. However, privacy is not the same as security. Hacking and fraud can affect cryptos as well as other forms of money and attacks will increase with the value of the currencies. Bitcoin At The Helm Of Crypto-Currency Market Chart 4Bitcoin Slows Bitcoin Slows Bitcoin Slows Bitcoin has cemented its status as the number one currency in the crypto-verse.6 It is considered to be the first crypto-currency created, it is the most widely accepted, it is touted as a store of value or “digital gold,” and it is the most featured in quoting alternative crypto-currency pairs across crypto exchanges. As it stands, Bitcoin accounts for around 42% of total crypto-currency market capitalization.7 This share has declined from around 65% at the start of 2021 on the back of the frenzied rise of several alternative coins.8 But rising risks to Bitcoin’s standing will cause the entire crypto-market to retreat. In a Special Report penned in February, BCA Research’s Chief Global Strategist Peter Berezin argued that Bitcoin is more of a trend than a solution and that its usefulness is diminishing. Bitcoin’s transaction speed is slowing and its transaction cost is rising (Chart 4). Slowing speed and rising cost on the Bitcoin network are linked to a scalability problem. The crypto-currency’s network has a limited rate at which it can process transactions related to the fact that records (or “blocks”) in the Bitcoin blockchain are limited in size and frequency. This means that one of its fundamental justifications, transactional speed, will become less attractive over time, should the network not address these issues. Bitcoin also consumes a significant amount of energy, a controversy that is gaining traction in the crypto-currency market after Elon Musk, the “techno-king” of Tesla, cited environmental concerns in reversing his decision to accept Bitcoin payment for his company’s electric vehicles. Energy consumption rises as more coins are mined, since mining each new Bitcoin becomes more computer-power intensive. The need for computing power and energy will continue to increase until all 21 million Bitcoins (total supply) are mined, which is currently estimated to occur by the year 2140. Strikingly, the energy needed to mine Bitcoin over a year are comparable to a small country’s annual power consumption, such as Sweden or Argentina (Chart 5). Chart 5Bitcoin Consumes More Energy Than A Small Country … Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin also generates significant quantities of electronic waste (Chart 6). Chart 6… And Generates A Lot Of Electronic Waste Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin mining is heavily domiciled in China, which accounts for 65% of global mining activity (Figure 1). China’s energy mix is dominated by coal power, which makes up approximately 65% of the country’s total energy mix even after a decade of aggressive state-led efforts to reduce coal reliance. Of this, coal powered energy makes up approximately 60% of Bitcoin’s energy mix in China.9 With several countries aiming to minimize carbon emissions, and with approximately 60% of Bitcoin mining powered by coal-fired energy globally,10 Bitcoin imposes a major negative environmental impact. Figure 1Bitcoin Mining Well Anchored In Asia Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin does not shape up well when compared to gold’s energy intensity either. Bitcoin mining now consumes more energy than gold mining over a single year. While the energy difference is not large, the economic value is. Gold’s energy consumption to economic value trade-off is lower than that of Bitcoin. The production value of gold in 2020 was close to $200 billion, while Bitcoin was measured at less than $25 billion (Chart 7A). On a one-to-one basis, gold even has a lower carbon footprint than Bitcoin (Chart 7B). Chart 7AGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 7BGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Crypto-currency energy consumption and carbon footprint will attract the attention of government regulators. Of course, not all crypto-currencies are heavy polluters. But if the supply of cryptos is constrained by mining difficulties then they will require a lot of energy. If the supply is not constrained then the price will be low. Government Regulation Is Coming Environmental concerns point to the single greatest threat to crypto-currencies – the Leviathan, i.e. the state. In this sense the crypto market’s wild fluctuations on May 19, at the mere whiff of tougher Chinese regulation, are a sign of what is to come. Governments around the world have so far left crypto-currencies largely unregulated but this laissez-faire attitude is already changing. Environmental regulation has already been mentioned. Governments will also be eager to expand their regulatory powers to “protect” consumers, businesses, and banks from extreme volatility in crypto markets. But investors will underrate the regulatory threat if they focus on these issues. At the most basic level, governments around the world will not sit idly by and lose what could become significant control of their monetary systems. The ability to establish and control legal tender is a critical part of economic sovereignty. Governments won control of the printing press over centuries and will not cede that control lightly. If crypto-currencies are adopted widely, then finance ministries and central banks will lose their ability to manipulate the money supply and the general level of prices effectively. Politicians will lose the ability to stimulate the economy or keep inflation in check. Most importantly, while one may view such threats as overblown, it is governments, not other organizations, that will make the critical judgment on whether crypto-currencies threaten their sovereignty. Throughout the world, most crypto-currency exchanges are regulated to prevent money laundering. Crypto-currencies are not legal tender and, aside from Bitcoin, their use is mostly banned in China (Table 1). However, more specialized regulation that targets energy and economic use has yet to be brought into law across the world. Table 1World Governments Will Not Relinquish Hard-Fought Monopolies Over Money Supply Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In China, initial coin offerings (ICOs – the equivalent of an initial public offering on the stock market) and trading platforms are banned from engaging in exchanges between the yuan and crypto-currencies or tokens. In fact, China recognizes crypto-currencies only as virtual commodities or virtual property. India is another country where exchanges and ICOs are banned. While crypto-currencies are not banned, they are not legal tender. Indian policymakers have recently proposed banning crypto-currencies, however. The proposed legislation is one of the world’s strictest policies against crypto-currencies. It would criminalize possession, issuance, mining, trading, and transferring crypto-assets. If the ban becomes law, India would be the first major economy to make holding crypto-currency illegal. Even China, which has banned mining and trading, does not penalize possession. In the US, Secretary of the Treasury Janet Yellen has already expressed concerns regarding the illicit use of cryptos for supposed criminal gain.11 She is in alignment with European Central Bank President Christine Lagarde. Because of the anonymity of crypto-currencies, identifying users behind illicit transactions is difficult. This means regulators face headwinds in identifying transactions that are made for criminal gain, as compared to fiat transactions. Governments have long dealt with the anonymity of cash but they have ways of monitoring bank accounts and paper bills. Crypto-currencies are beyond their immediate sight of control and therefore will attract growing scrutiny and legislative action in this regard. The Colonial Pipeline ransomware attack on May 7, which temporarily shuttered about 45% of the fuel supply line for the eastern United States, illustrates the point. The DarkSide group of hackers who orchestrated the attack demanded a ransom payment of $4.4 million worth of Bitcoin, which Colonial Pipeline paid them on May 7. Shortly thereafter, unspecified “law enforcement agencies” clawed back the $4.4 million from the hackers’ account (transferring it to an unknown address) and DarkSide lost access to its payment server, DOS servers, and blog. This episode should not be underrated. It was a successful, large-scale cyber-attack on critical infrastructure in the world’s most powerful country. It highlighted the illicit uses to which crypto-currencies can be put. True, criminals demand ransoms in fiat money as well – and many crypto-currency operators will distance themselves from the criminal underworld. Nevertheless governments will give little slack to an emerging technology that presents big new law enforcement challenges and is not widely used by the general public. Ultimately governments will pursue their sovereign interests in controlling money, the economy, and trade, listening to their banking lobby, expanding their remit to “protect” consumers, and cracking down on illicit activity. Governments are not capable of abolishing crypto-currencies altogether, or the underlying technology of blockchain. But they will play a large and growing role in regulating them. Central Banks Advancing On Digital Currencies Central bank digital currencies (CBDCs) will leave crypto-currencies in the realm of speculative assets. CBDCs are a form of digital money denominated in a country’s national unit of account and represent a liability on a central bank’s balance sheet. This is different from current e-money that represents a claim on a private financial institution’s balance sheet. It is also different from crypto-currencies, because there is a central authority behind a CBDC, unlike with crypto-currencies due to their decentralized nature. In China, the People’s Bank of China (PBoC) has suggested its rollout of a digital yuan is “ready” despite no release to date. Beta testing is ongoing in several provinces. The PBoC’s justification for a digital yuan comes from China’s growing cashless economy. The transition away from cash is largely thanks to mobile payment platforms like Alibaba’s Alipay and Tencent’s WeChat Pay, which, between the two of them, control almost the entire mobile payments market of some 850 million users. There is a significant amount of systemic risk in this system – one reason why Chinese authorities have recently subjected these companies to new scrutiny and regulation. Should Alibaba or Tencent go bankrupt, the local payment system will crash. The PBoC’s efforts will increase competition in the local payments space and reduce this systemic risk. Policymakers are also concerned that as Chinese citizens choose to hold their money in digital wallets provided by Alibaba and Tencent instead of bank accounts, liquidity is being drained from the traditional banking system, putting deposit levels at banks under strain, and posing risks to liability matching. The digital yuan will still involve a third party, unlike crypto-currencies which do not. Doing away with commercial banks is not a reality – indeed the Chinese Communist Party seeks to buttress the state-owned commercial banks in order to maintain control of the economy. What the digital yuan does, and other CBDCs will do too, is utilize blockchain technology, which is faster and more secure than traditional payment networks. In the US, the Fed has been studying the viability of a CBDC US dollar. The Fed has stated that it is carefully exploring whether a CBDC will lead to “safer, less expensive, faster, or otherwise more efficient payments.” While the Fed has yet to find a single standout case for a CBDC US Dollar, Fed Chair Jerome Powell said last year that the US has a “competitive payments market” with “fast and cheap services, particularly in comparison to other nations exploring a CBDC.” To date, the Fed’s observation is that many of the challenges that CBDCs hope to address do not apply to the US, including disuse of physical cash, narrow reach or high concentration of banking, and weak infrastructure for payment systems. Rather, the Fed is more focused on developing the FedNow real-time payment system for private banks. This is much the same as in Europe, where physical cash still plays a major role in day-to-day economic activity and where local payment systems are fast and secure. But central banks around the world continue to engage in work centered around CBDCs (Charts 8A and 8B) – and China’s progress will encourage others to move faster. Advanced economies are mostly interested in creating a safer and more efficient payment system, while emerging and developed economies have interest across several areas such as financial stability, monetary policy setting, and inclusiveness of banking, as well as efficiency and safety (Chart 9). CBDCs are especially attractive to emerging market policy makers at targeting those who lack access to traditional banking. Chart 8ACentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 8BCentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 9Central Banks CBDC Interest Areas Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In remote areas, access to banking is scarce and expensive. CBDCs can help solve this problem. Individuals would have CBDC accounts directly on a central bank ledger. They could then access their money and transact through a digital wallet application that is linked to the CBDC account. Giving people access to digital currency would allow them to transact quickly, in remote settings, without the need of hard currency. Monetary policy transmission is also better in advanced economies. In emerging markets, there are bottlenecks in local financial markets. Looser central monetary policy does not always translate into cheaper financing across the economy. In remote and poverty stricken areas, monetary policy transmission is sticky, meaning high costs of borrowing can persist even through accommodative policy cycles. This is a smaller issue in advanced economies. Payment systems in advanced economies are due an overhaul in security and efficiency, and CBDCs and blockchain technology will provide this. CBDCs will prove to be just as efficient to transact with as any crypto-currencies available today. CBDCs will also be legal tender and accepted by all vendors. The anonymity factor will be lost but this will not be a problem for most users (whereas legal issues will become a problem for crypto-currencies). The probability of central banks issuing CBDCs in both the short and medium term, both in the retail and wholesale space, is rising. If advanced economies like those of the G7 issue CBDCs soon, policy makers will undoubtedly ensure the use of it over the currently circulating and partially accepted crypto-currencies. The endgame will leave crypto-currencies in the highly speculative asset class, perhaps even in the black market where anonymity is valued for transactions that wish not to be tracked. Investment Takeaways Prices of crypto-currencies may continue to rise given sky-high fiat money creation amid the COVID pandemic and ultra-low interest rates. Digitalization is the natural next step in the evolution of money from precious metals to paper banknotes to electronic coin. But the market leader, Bitcoin, is encountering more headwinds. The primary case for the use of Bitcoin is challenged due to slowing transaction speeds and rising transaction costs. The virtual currency is primarily mined using coal-powered energy, resulting in growing scrutiny from governments and consumers. Government regulation is entering the ring and policymakers will take an increasingly heavy-handed role in trying to ensure that cryptos do not undermine economic sovereignty, financial stability, and law and order. When central banks begin to rollout digital currencies, especially those domiciled in advanced economies, crypto-currencies as medium of exchange will lose much of their allure. Crypto-currencies will remain as anti-fiat currencies and speculative assets. Risks To The View Given the controversy surrounding crypto-currencies, it is only fair to state outright the risks to our view. We would also recommend clients read our colleague Dhaval Joshi’s latest bullish take on Bitcoin. First, scaling up Bitcoin’s network and processing transactions in batches instead of single transactions will resolve transaction time and cost risks, restoring efficiency. This is a clear solution to efficiency concerns. However, scaling and batching transactions are not on the immediate horizon of Bitcoin developers. Bitcoin’s network will still need to undergo another “halving” in order for this risk to subside and for the network to scale. A halving of the network will only occur again in 2024.12 Second, on the environment: Bitcoin mining is not solely dependent on fossil fuel energy that gives it a “dirty” footprint. Renewables already make up some 25% of Bitcoin mining. Increasing the use of renewables in Bitcoin’s energy mix will help lower its environmental impact. However, this is easier said than done. Global renewable energy has yet to scale up to a point where it can consistently out-supply existing fossil-fuel energy. Mining hardware also has its associated carbon footprint that would need to be addressed. And location matters too. Crypto-currency mining farms are large-scale projects. Simply uprooting operations to a country that could lower the carbon footprint of a mining farm or two is not viable due to the costs involved. Hence crypto-currency mining will probably continue to be a “dirty” operation but a rapid shift to renewables would challenge our thesis. Bitcoin’s network is also based off a “proof of work” protocol. Miners must prove that a certain amount of computational effort has been expended for confirming blocks on the network, allowing transactions to be processed. Proof of work is energy intensive. Other crypto-currencies, like Ethereum, will adopt a “proof of stake” protocol. Simply put, transactions are confirmed by users and their stake in the associated crypto-currency. Proof of stake is less energy intensive compared to proof of work. Third, as to government regulation, the longer policymakers take to enact legislation targeting crypto-currencies, the larger their market will grow. Regulation in China and India may set a benchmark for major economies but not all will follow in the Asian giants’ footsteps. Some governments have been slow to study crypto-currencies, meaning legislation aimed at governing or regulating them may still be long in coming. Innovation is a good thing and free economies will not wish to restrain crypto-currencies or blockchain technology unduly, for fear of missing out. Fourth, on CBDCs, some central banks may only adopt them based on their respective economic needs. However, rising crypto-currency populism drives associated economic risks which can force the hands of central banks to adopt CBDCs in lieu of said needs. Each country faces unique challenges. Some central banks may not want to be left behind even if they believe their policy framework is facilitating economic activity efficiently. While the Fed has stated that it will not adopt a CBDC for the primary reason of ensuring payment security since it believes it already has a safe system in place, this view will change. The Fed could justify a move to a CBDC US dollar on the single basis of transitioning to a more sophisticated technology for the future. The Fed will not want to be caught behind the curve considering the PBoC is priming its digital yuan for release soon. Technological leadership is a strategic imperative of the United States and that imperative applies to financial technology as well as other areas.   Guy Russell Research Analyst GuyR@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Muyao Shen, “China Reiterates Crypto Bans From 2013 and 2017”, coindesk, May 18, 2021, coindesk.com. 2 As of May 11, 2021. 3 There are several other reasons or “problems” that crypto-currencies are created for or to solve, but speed and privacy form the basis of crypto-currencies first coming into existence. 4 Not all crypto-currencies transact in less than an hour. But there are many that transact in several minutes and in some cases, mere seconds. As the leading crypto-currency, Bitcoin takes approximately one hour for a transaction to be fully verified over its network. 5 “McKinsey’s Global Banking Annual Review”, McKinsey, Dec. 9, 2020, mckinsey.com. 6 We use Bitcoin as an example to understand the risk and impact of forthcoming government regulation and competition. Because of Bitcoin’s status, any significant risks that threaten the crypto-currency’s standing as the number one currency will threaten the entire market. 7 As of May 20, 2021. Figure varies daily. See www.coinmarketcap.com for more information. 8 Alternative currencies such as Ethereum, Ripple, Binance Coin, Dogecoin, and Cardano have chipped away at Bitcoin’s crypto-market dominance through 2021. 9 According to The Center For Alternative Finance, The University Of Cambridge. 10 According to The Center For Alternative Finance, The University Of Cambridge. 11 Data on the use of crypto-currencies for illicit activitiessays otherwise. Of all crypto-currency transactions, it is estimated that only 2.1% are used for illicit activities. See “2021 Crypto Crime Report”, Chainalysis, chainalysis.com. 12 A Bitcoin halving is when the reward for mining Bitcoin transactions is cut in half. This event also cuts Bitcoin's inflation rate and the rate at which new Bitcoins enter circulation, in half. Bitcoin last halved on May 11, 2020.

Highlights The drubbing that cryptocurrencies have received over the past two weeks is just a taste of things to come. Crypto markets will continue to face tighter regulation, as this week’s announcements from China and the US Treasury underscore. The hope that cryptocurrencies can ever truly “go green” is wishful thinking. Given their decentralized nature, cryptocurrencies require real resources to be expended to permit secure transactions to take place. In addition to their technical limitations, cryptocurrencies face a fundamental constraint, which we dub the “Crypto Impossibility Theorem.” The Crypto Impossibility Theorem states that cryptocurrencies will be viable only if they offer a higher return than equities. The assumption that cryptos can generate a return in excess of equities is almost certain to be false since it would require that cryptocurrency holdings rise more quickly than income in perpetuity. In the near term, the pain in crypto markets could drag down other speculative assets such as tech stocks. In the long term, diminished investor interest in cryptos will benefit the stock market, as investor attention focuses back on equities. Cryptos: Can’t Have It All Investors who track the cryptocurrency market might be aware of the “blockchain trilemma.” It posits that cryptocurrencies can possess only two of the following three attributes: decentralization, security, and scalability. Bitcoin is both highly decentralized and reasonably secure. However, because control of the Bitcoin blockchain is distributed across thousands of individual computer nodes, it is also very slow. The Bitcoin network can barely process five transactions per second, compared to over 20,000 for the Visa network (Chart 1). The average fee for a Bitcoin transaction is around $30, a number that has risen over the past few years (Chart 2). Chart 1Speed Of Transactions, Or Lack Thereof Speed Of Transactions, Or Lack Thereof Speed Of Transactions, Or Lack Thereof Chart 2Rising Cost Per Transaction Rising Cost Per Transaction Rising Cost Per Transaction   The elaborate puzzles that the Bitcoin algorithm must solve to verify transactions are extremely energy intensive. Bitcoin mining consumes more energy than entire countries such as Sweden, Argentina, and Pakistan (Chart 3). About two-thirds of Bitcoin mining currently takes place in China, often using electricity generated by burning coal. Chart 3Bitcoin And Ethereum: How Dare You! The Crypto Impossibility Theorem The Crypto Impossibility Theorem Some claim that Bitcoin and other cryptocurrencies are shifting to renewable energy sources, a trend that will continue in the years ahead. However, this argument misses the point, which is that the “proof of work” mechanism that underpins Bitcoin requires that real resources be expended. Suppose that all Bitcoin mining could be performed entirely for free using solar energy. This would reduce the cost of running a “mining rig,” incentivizing more mining. The Bitcoin algorithm operates in such a way that the difficulty of mining coins increases as the total computational power of all miners grows. In this computational rat race, miners would need to purchase more servers with ever more powerful specifications to keep up with their competitors. And semiconductors do not grow on trees. It takes real resources to produce them. As this recent Bloomberg article pointed out, Taiwan Semiconductor generates almost 50% more greenhouse emissions than General Motors. Like Bitcoin, Ethereum uses the “proof of work” mechanism to verify transactions. There have been active discussions to shift Ethereum to a “proof of stake” mechanism, which would greatly expedite transactions.1 However, some have argued that a proof of stake system would degrade security, allowing for “double-spend attacks” where someone transfers coins to someone else but then spends the coins before the transaction is completed. The Crypto Impossibility Theorem We will not delve any further into the technical nature of the blockchain trilemma other than to note that it poses a serious challenge to the entire cryptocurrency project. Instead, let us highlight another obstacle that has received less attention – one that could be even more damaging for the prospects of cryptocurrencies in the long run. Let us hyperbolically call it the “Crypto Impossibility Theorem.” The Crypto Impossibility Theorem states that a cryptocurrency will be viable only if it offers a higher return than equities. As we discuss below, the assumption that cryptos can generate a return in excess of equities is almost certain to be false since it would require that cryptocurrency holdings rise more quickly than income in perpetuity. This implies that the value that investors currently attach to cryptos will turn out to be illusory. To see the theorem in action, recall that money serves three functions: As a unit of account, as a medium of exchange, and as a store of value. It is doubtful that anyone seriously thinks that the price tag on a box of cereal will ever be displayed in units of Bitcoin, ether, or any of the various dog coins currently in vogue. Thus, we can scratch “unit of account” off the list of possible crypto uses. What about medium of exchange? One can imagine a scenario where the prices of goods and services are still listed in dollars, but one may transfer the equivalent in cryptocurrencies to purchase them. However, this raises an obvious question: Why would anyone choose to hold a cryptocurrency if wages and prices are denominated in fiat currencies such as US dollars or euros? The only possible answer is that people must see cryptocurrencies as fulfilling the third function of money, namely being a store of value. Would people be willing to hold cryptocurrencies if their prices generally moved sideways? It is doubtful. Cryptocurrencies are risky. Cryptocurrency accounts are not subject to deposit insurance. Crypto prices are also extremely volatile. During the pandemic, the S&P 500 fell by 34%, but the price of Bitcoin sank by an even greater 53%. Other cryptocurrencies fared even worse. In contrast, the trade-weighted US dollar strengthened by about 4% while gold prices only fell marginally (Chart 4). Thus, to incentivize people to hold cryptos, the prospective capital gain has to be large enough to offset the inherent volatility in owning these currencies. Chart 4Cryptocurrencies Fared Badly During Last Year’s Equity Sell-Off The Crypto Impossibility Theorem The Crypto Impossibility Theorem This is where the Crypto Impossibility Theorem comes in. Unlike dividend-paying stocks, cryptocurrencies do not provide any income to their holders. Thus, even if cryptos were just as risky as stocks, the price of cryptos would still need to rise more than the price of stocks in order to ensure that investors remain indifferent between the two asset classes. In practice, as the experience of the pandemic demonstrates, cryptos are even riskier than stocks. Thus, the expected return on cryptos has to exceed the expected increase in stock prices by more than the dividend yield. The problem for crypto holders is that this is not mathematically possible. Even if one controls for the rise in price-earnings multiples over time, equity returns have generally exceeded nominal GDP growth (Table 1). Hence, if cryptos need to offer superior returns to equities, and if the return on equities is at least equal to nominal GDP growth, then the market capitalization of cryptocurrencies will not only end up rising faster than for stocks, it will rise faster than aggregate national income. In a digital world where people need ever-less money to facilitate transactions, there is no good reason to expect this to happen. Table 1Equity Returns And GDP Growth The Crypto Impossibility Theorem The Crypto Impossibility Theorem A Fashion Choice Crypto-optimists might argue that the required rate of return to holding cryptos will decline as the market matures. This is wishful thinking. Equities derive their value from the fundamentals of a company’s business. In contrast, cryptocurrencies have no intrinsic value. Their value is whatever others are willing to pay for them. Not only does this make cryptocurrencies inherently more risky than equities, it also makes them highly susceptible to fashion trends. It is not surprising that many upstart cryptocurrencies have crafted ties with celebrities and other “influencers.” The whole point is to get enough people interested in a cryptocurrency to generate a feedback loop of wider adoption, thus allowing the currency’s early backers to cash out. The drubbing that cryptocurrencies have received over the past two weeks is just a taste of things to come. In this sense, cryptocurrencies are even more vulnerable to affinity scams than other assets such as precious metals. While apocalyptic warnings of “currency debasement” have long been used to sell bullion, at least with gold and silver, you truly do get something that is in short supply. In the case of cryptocurrencies, while the supply of any individual cryptocurrency may be limited, the overall supply is unbounded. This means that the average price of each currency is likely to rise much less than the aggregate value of all cryptocurrencies, making the entire asset class even less viable over time.   Cryptogeddon The drubbing that cryptocurrencies have received over the past two weeks is just a taste of things to come. As Matt Gertken and Guy Russell discuss in this week’s Geopolitical Strategy report, crypto markets will continue to face tighter regulation (Table 2). Just this week, China reiterated its ban on financial companies offering cryptocurrency services. As part of its broader effort to crack down on tax evasion, the US Treasury Department also announced that it will require any cryptocurrency transfer worth $10,000 or more to be reported to the IRS. Table 2Regulation Of Cryptos: What Can And Cannot Be Done The Crypto Impossibility Theorem The Crypto Impossibility Theorem The blockchain trilemma will make it impossible for cryptos to overcome ESG concerns, while the Crypto Impossibility Theorem will prevent cryptocurrencies from ever being stable stores of value. In the meantime, an ebbing of input price inflation will take some of the wind out of the sails from the argument that cryptos are an indispensable hedge against the “inevitable” debasement of fiat monies. Chart 5 shows that DRAM prices have rolled over. Lumber prices have dropped 11% so far this week. Corn, soybean, and steel prices have also backed off their highs. Cryptos are like sharks; they need to move forward or they will sink. Back when they were unknown to most investors, a speculative case could have been made for buying cryptos. However, that case vanished earlier this year when the aggregate value of cryptocurrencies briefly surpassed the entire stock of US dollars in circulation (Chart 6). Even with the recent correction, there are 17 cryptocurrencies with market capitalizations above $10 billion (Table 3). Chart 5To The Moon And Back? To The Moon And Back? To The Moon And Back? Chart 6Aggregate Value Of Cryptos Briefly Surpassed The Entire Stock Of US Dollars In Circulation Aggregate Value Of Cryptos Briefly Surpassed The Entire Stock Of US Dollars In Circulation Aggregate Value Of Cryptos Briefly Surpassed The Entire Stock Of US Dollars In Circulation Table 3Close To 20 Cryptos Have A Market Cap In Excess Of US$10bn The Crypto Impossibility Theorem The Crypto Impossibility Theorem What will the ongoing crypto collapse mean for the broader investment landscape? In the near term, the pain in crypto markets could drag down other speculative assets such as tech stocks. In the long term, diminished investor interest in cryptos will benefit the stock market, as investor attention focuses back on equities. For the broader economy, the impact of a crypto bear market will be limited. The banking system has very little exposure to cryptos. There will be a modest adverse wealth effect from falling crypto prices. However, the inability of a few laser-eyed crypto traders to buy their Lambos is hardly going to matter much against the backdrop of strong stimulus-fueled consumption growth in the US and a number of other economies. Investors should continue to overweight stocks in a global asset portfolio, favoring value over growth, cyclicals over defensives, and non-US stocks over their US peers. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Proof of Work (PoW) and Proof of Stake (PoS) are two methods used to ensure the integrity of a coin’s ledger or record of transactions. PoW achieves this by requiring miners (those who add transactions to the ledger) to solve a time-consuming mathematical puzzle. PoS achieves this through a different mechanism, where anyone who stakes their own coin can be randomly selected to add new transactions to the ledger. Those holding or “staking” more coin have a higher probability of being selected. Global Investment Strategy View Matrix The Crypto Impossibility Theorem The Crypto Impossibility Theorem Special Trade Recommendations The Crypto Impossibility Theorem The Crypto Impossibility Theorem Current MacroQuant Model Scores The Crypto Impossibility Theorem The Crypto Impossibility Theorem

Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand.  This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption.  We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year.  This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023.  Chart 3US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong China Refinery Runs Remain Strong China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Markets Remained Balanced Markets Remained Balanced Chart 7Inventories Continue To Draw Inventories Continue To Draw Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond.   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 Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 RBOB Gasoline at a High RBOB Gasoline at a High Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices     Footnotes 1     Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights The reason to own stocks is not profit growth. The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will be lacklustre, at best. The reason to own stocks is that the ultimate low in the T-bond yield is yet to come. This ultimate low in the T-bond yield will define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks… …and tilt towards long-duration growth sectors and growth-heavy stock markets such as the S&P500 that will benefit most from the final collapse in yields. The correction in DRAM, corn, and lumber prices suggests that the recent mania in inflation expectations is about to end. Fractal trade shortlist: copper and tin are fragile, go long T-bonds versus TIPS. Feature Chart of the WeekGlobal Profits Surged During The Credit Boom, But Have Gone Nowhere Since Global Profits Surged During The Credit Boom, But Have Gone Nowhere Since Global Profits Surged During The Credit Boom, But Have Gone Nowhere Since The main reason to own stocks is not what you think. The usual long-term argument to own stocks is based on profit growth – specifically, that an uptrend in profits drives up stock prices. Except that since 2008, this is not true (Chart of the Week and Chart I-2). Profits have barely grown, yet the global stock market has doubled.1 Chart I-2Since The Credit Boom Ended, Global Profits Have Barely Grown Since The Credit Boom Ended, Global Profits Have Barely Grown Since The Credit Boom Ended, Global Profits Have Barely Grown As profits have barely grown since 2008, the main reason that the global stock market has doubled is that the valuation paid for those profits has surged. Looking ahead, we expect this to remain the main reason to own stocks. The Reason To Own Stocks Is Not Profit Growth Profits are the product of sales and the profit margin on those sales. During the credit boom of the nineties and noughties, the strong tailwind of credit creation supercharged sales growth. At the same time, the profit margin on those sales trended higher (Chart I-3). Chart I-3Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Hence, in the decade leading up to 2008, global stock market profits surged, outstripping both sales and world GDP. Then the credit boom ended, and profits languished, because: Absent the tailwind from the credit boom, sales growth moderated. The profit margin trended lower. In the post-pandemic years, we expect both trends to persist. The credit boom is not coming back. Furthermore, as the pandemic recession was not protracted, sales are not at a depressed level from which they can play a sharp catch-up, as they did after the 2008 recession and the 2015 emerging markets recession. The structural downtrend in the profit margin will continue. Meanwhile, the structural downtrend in the profit margin will continue. Governments are desperate to mitigate – or at least, contain – the ballooning deficits that have paid for their pandemic stimuluses. Raising corporate taxes from structurally depressed levels is an easy and politically expedient response, as we have already seen from both the Biden administration in the US, and the Johnson administration in the UK. Higher corporate taxes will weigh on structural profit margins (Chart I-4). Chart I-4Corporate Taxes Will Rise From Structurally Depressed Levels Corporate Taxes Will Rise From Structurally Depressed Levels Corporate Taxes Will Rise From Structurally Depressed Levels The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will continue to be lacklustre, at best. The Reason To Own Stocks Is That The Ultimate High In Valuations Is Yet To Come To repeat, the main reason that the global stock market has doubled since 2008 is that its valuation has surged (Chart I-5). Chart I-5The Main Driver Of The Stock Market Has Been Valuation Expansion The Main Driver Of The Stock Market Has Been Valuation Expansion The Main Driver Of The Stock Market Has Been Valuation Expansion In turn, the stock market’s valuation has surged because bond yields have plummeted. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The main reason that the global stock market has doubled since 2008 is that its valuation has surged. Through 2012-13, the decline in the Italian BTP yield, by signifying the fading of euro break-up risk, boosted stock valuations. In more recent years though, it has been the US T-bond yield that has been more influential in driving the global stock market’s valuation (Chart I-6). Chart I-6The Stock Market's Valuation Expansion Is Due To Lower Bond Yields The Stock Market's Valuation Expansion Is Due To Lower Bond Yields The Stock Market's Valuation Expansion Is Due To Lower Bond Yields But the crucial point to grasp is that the relationship between the declining bond yield and stock market valuation becomes exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but considerably more downside. This extra riskiness of bonds means that investors demand a diminishing risk premium on equities versus bonds. So, as bond yields decline, the required return on equities – which equals the bond yield plus the risk premium – collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-7 and Chart I-8 demonstrate this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market’s valuation is on the linear right scale. The logarithmic versus linear scale visually demonstrates that at a lower bond yield, a given change in the bond yield has a much greater impact on the stock market’s valuation. Chart I-7The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential Chart I-8When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge Specifically, if the 30-year yield in the US reached the recent low achieved in the UK, it would boost the stock market’s valuation by nearly 50 percent. We fully expect this to happen at some point in the coming years because of The Shock Theory Of Bond Yields which we introduced in last week’s report. In a nutshell, the shock theory of bond yields states that each successive deflationary shock takes the bond yield to a lower structural level, until it can go no lower. Although it is impossible to predict the timing and nature of individual shocks such as the pandemic, it is easy to predict the statistical distribution of shocks. On this basis, the likelihood of a net deflationary shock is 50 percent within the next three years, and 81 percent within the next five years. Whatever that deflationary shock is, and whenever it arrives, it will mark the ultimate low in the 30-year T-bond yield – at a level close to the recent low in the UK. This ultimate low in the T-bond yield will also define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks. And tilt towards long-duration growth sectors that will benefit most from the final collapse in yields. Growth sectors and growth-heavy stock markets such as the S&P500 will continue to outperform, as they have done consistently since 2008. The Inflation Bubble Is Bursting   The last couple of months has seen a mania in inflation expectations. As industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities led to understandable spikes in their prices. These commodity price increases then unleashed fears about inflation. As investors sought inflation hedges, it drove up commodity prices more broadly … which added to the inflation fears…which added further fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The inflation bubble is bursting. But now it seems that the indiscriminate rally is over. DRAM prices have rolled over, belying the thesis that there is widespread shortage in semiconductors (Chart I-9). More spectacularly in the past week, the corn price has tumbled by 12 percent while the lumber price has slumped by 25 percent (Chart I-10). Chart I-9DRAM Prices Have ##br##Rolled Over DRAM Prices Have Rolled Over DRAM Prices Have Rolled Over Chart I-10Lumber Prices Are Correcting, Will Other Commodities Follow? Lumber Prices Are Correcting, Will Other Commodities Follow? Lumber Prices Are Correcting, Will Other Commodities Follow? Given that the commodity rally was indiscriminate, there is a danger that any correction will spread into other commodities like the industrial metals, copper and tin – especially as their fractal structures are at a level of fragility that has identified previous turning points in 2008, 2011, 2015, 2017 and 2020 (Chart I-11 and Chart I-12). Chart I-11Copper's Fractal Structure Is Fragile Copper's Fractal Structure Is Fragile Copper's Fractal Structure Is Fragile Chart I-12Tin's Fractal Structure Is Fragile Tin's Fractal Structure Is Fragile Tin's Fractal Structure Is Fragile In any case, the mania in inflation expectations is about to end. An excellent way to play this is to expect compression in the market implied inflation rate in T-bond yields versus TIPS yields (Chart I-13). Chart I-13The Mania In Inflation Expectations Is About To End The Mania In Inflation Expectations Is About To End The Mania In Inflation Expectations Is About To End Hence, this week’s recommended trade is to go long the 10-year T-bond versus the 10-year TIPS, setting a profit target and symmetrical stop-loss at 3.6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  To clarify, Chart 2 shows world stock market earnings per share, both 12-month forward and 12-month trailing. Whereas Charts 1 and 3 show sales and net profits (not per share). 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