Financial Markets

Highlights Fiscal stimulus is no longer a free lunch. US mortgage applications are down by 20 percent since the start of February. With rising bond yields now starting to choke private sector borrowing, bond yields are nearing an upper-limit, and even a reversal point. In which case, the tide out of defensives into cyclicals, and growth into value, will be a tide that reverses. New 6-month recommendation: underweight US banks (XLF) versus consumer staples (XLP). Fractal trade shortlist: US banks, bitcoin, ether, and GBP/JPY. Feature Chart of the WeekMortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Why would anybody not get excited about trillions of dollars of fiscal stimulus? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield, it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending has crowded out a dollar of private sector spending. In this case, fiscal stimulus will have no impact on GDP. The fiscal multiplier will be zero. Under some circumstances though, fiscal stimulus does not crowd out the private sector and the fiscal multiplier is extremely high. 2020 was the perfect case in point. As the pandemic gripped the world, much of the private sector was on its knees. Or to be more precise, in lockdown at home, doing nothing, receiving no income, and unwilling and unable to borrow. In such a crisis, the government became the ‘borrower of last resort’. It could, and had to, borrow at will to replace the private sector’s lost income and thereby to stabilise the collapse in demand. With no competition from private sector borrowers for the glut of excess savings, bond yields stayed depressed. Meaning that fiscal stimulus was a free lunch: it had lots of benefit with little cost (Chart I-2). Chart I-2Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Is No Longer A Free Lunch Covid-19 is still with us, and could be with us forever. Yet the economy will adapt and even thrive with structural changes, such as decentralisation, hybrid office/home working, a shift to online shopping, and less international travel. In fact, all these structural changes were underway long before Covid-19. Meaning that the pandemic was the accelerant rather than the cause of what was happening to the economy anyway. As the private sector now gets back on its feet to restructure, spend, and invest accordingly, fiscal stimulus is no longer a free lunch. Fiscal stimulus is most effective when it is not pushing up the bond yield. To repeat, last year’s massive fiscal stimulus was highly effective because it had little impact on the bond yield, so there was no crowding out of private sector borrowing. The markets have fully priced the 2021 stimulus, but not the crowding out. However, the most recent stimulus package has pushed up the bond yield or, at least, is a major culprit for the recent spike in yields. Hence, there will be some crowding out of private sector borrowing. Worryingly, US mortgage applications, for both purchasing and refinancing, are down by 20 percent since the start of February (Chart of the Week and Chart I-3). Chart I-3Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent The resulting choke on private sector borrowing and investment will at least partly negate any putative boost from this fiscal stimulus. The concern is that the markets have fully priced the stimulus, but not the crowding out. Time To Rotate Back In our February 18 report, The Rational Bubble Is Turning Irrational, we warned that high-flying tech stocks were at a point of vulnerability. Specifically, since 2009, the technology sector earnings yield had always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of a ‘rational bubble.’ In February, this envelope was breached, indicating that tech stock valuations were in a new and irrational phase (Chart I-4). Chart I-4The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The warning proved to be prescient. In the second half of February, tech stocks did sell off sharply and entered a technical correction.1 As a result, tech-dominated stock markets such as China and the Netherlands also suffered sharp declines. Proving once again that regional and country stock market performance is nothing more than an extension of sector performance (Chart I-5). Chart I-5As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets But the aggregate stock market has remained more resilient than we expected, and is only modestly down versus its mid-February peak. The reason is that while highly-valued growth stocks suffered the anticipated correction, value stocks continued to advance (Chart I-6). Chart I-6Time To Rotate Back Time To Rotate Back Time To Rotate Back We can explain this divergence in terms of the three components of stock market valuation: The bond yield. The additional return or ‘risk premium’ for owning stocks. The expected growth of earnings. Tech and other growth stocks are ‘long-duration’ assets meaning that their earnings are weighted into the distant future. Hence, for growth stocks the relevant valuation comparison is a long-duration bond yield, say the 10-year yield. Whereas for ‘shorter-duration’ value stocks the relevant valuation comparison is a shorter-duration bond yield, say the 2-year yield. Given that the 10-year yield has risen much more than the 2-year yield, the pain has been much more pronounced for growth stock valuations. Turning to the ‘risk premium’ for owning stocks, at ultra-low bond yields the risk premium just moves in tandem with the bond yield. Hence, as the 10-year yield has spiked, the combination of a rising yield plus a rising risk premium has doubled the pain for growth stock valuations. For a detailed explanation of this dynamic please see our February 18 report. Regarding the expected growth of earnings, the market believes that stimulus is much more beneficial for economically sensitive value stocks than for economically insensitive growth stocks. But now that we are at the point where rising bond yields are starting to choke private demand, the rise in bond yields is nearing a limit, and even a reversal point. In which case, the strong tide out of defensives into cyclicals will also be a tide that reverses. On this basis, and supported by the strong technical arguments in the next section, we are opening a new 6-month position: Underweight US banks versus US consumer staples, expressed as underweight XLF versus XLP. US Banks, Bitcoin, Ether, And The Pound This week we have identified susceptibilities to countertrend moves in three areas. The bullish groupthink in US banks is at an extreme. First, based on its fragile fractal structure, the (bullish) groupthink in US banks versus consumer staples is at an extreme approaching February 2016 (bearish), December 2016 (bullish), and March 2020 (bearish). All these previous extremes in fragility proved to be turning points in relative performance. If this proves true again, the next six months could see a reversal of US bank outperformance (Chart I-7). Chart I-7The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme Second, we are extremely bullish on the structural prospects for cryptocurrencies, and are preparing a report detailing the compelling investment case. Look out for it. That said, the composite fractal structures of both bitcoin and ethereum indicate that they are technically very overbought (Chart I-8 and Chart I-9). Accordingly, we are hoping for pullbacks that provide better strategic entry points for bitcoin at $40,000, and for ethereum at $1300. Chart I-8Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Chart I-9Ethereum Is Technically Overbought Ethereum Is Technically Overbought Ethereum Is Technically Overbought Third, the UK’s Covid-19 vaccination program was one of the fastest out of the blocks. As the vaccination rate quickly rose to over half the adult population (based on at least one vaccination dose), the pound was a major beneficiary. But now, the UK vaccination program is facing the hurdle of reduced supplies. Additionally, there is the danger that the third wave of infections in Continental Europe washes onto the shores of Britain. Hence, the recent strong rally in the pound is susceptible to a countertrend reversal (Chart 10). This week’s recommended trade is short GBP/JPY setting the profit target and symmetrical stop-loss at 2.2 percent. Chart I-10The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 A technical correction is defined as a 10 percent price decline. Fractal Trading System Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Asset Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Equity Market Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​​​

Highlights Biden has enough political capital to pass at least one more major piece of legislation. The next major bill will increase the budget deficit further, adding additional stimulus, though it will consist of structural reforms over a ten-year time frame and with a drag created by tax hikes. Our annual key views are on track: polarization has subsided but remains at peak levels from a historical point of view; structural reform is underway, although any chance of bipartisanship is slipping; the Republicans remain deeply divided despite some signs of regrouping. Investors should remain cyclically bullish although the sharp rise in bond yields, the bounce in the US dollar, China’s growth deceleration, and geopolitical risks all warrant tactical caution in the near term. Feature The first quarter of the year brought a few political surprises – from the Capitol Hill riot to Trump’s second impeachment – but the only significant surprise for the American investor was the Democratic victory in the Georgia Senate runoffs. This victory changed the policy setting, producing a Democratic majority in the US Senate and enabling the Biden administration to project three budget reconciliation bills (for FY2021, 2022, 2023) that require zero Republican votes.  The first of these bills was signed into law promptly as expected. The $1.9 trillion American Rescue Plan Act consists of short-term cash handouts and social spending that will supercharge an economic recovery that is rapidly accelerating due to the rollout of vaccines for COVID-19 (Chart 1). Chart 1American Rescue Plan Boosts GDP Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The second major piece of legislation, likely the budget reconciliation bill for FY2022, will consist of net increases to the budget deficit, thus further stimulating the economy, albeit along with structural reform, i.e. social safety net and tax hikes, and a 10-year time horizon. In the second quarter investors will learn the parameters of the bill through Biden’s address to a joint session of Congress, an idealistic presidential budget proposal, a more realistic House and Senate budget resolution, and an extended negotiation. Yet Biden’s second bill will probably not be signed into law until the third or even fourth quarter. Big Government Is Back The American Rescue Plan Act cements a new era of “Big Government” that should be ascribed not to any particular party but to underlying populist pressures in the United States. President Trump’s big-spending ways and pandemic relief packages had already produced a major step up in the government contribution to economic output, as shown in Chart 2, and this will go higher once Biden’s 8.7% of GDP bill is added to the mix. This increase in the government role is likely to last beyond the pandemic given that President Trump had already taught the Republicans that fiscal austerity does not win votes. Republicans will still be the party of “limited government” but that is a relative concept and they will not be able to win elections on a platform of slashing spending, at least not until stagflation returns. In the meantime they are out of power and tax-and-spend liberals rule the roost. Chart 2Era Of Big Government Is Back Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our updated budget projections show that the decline of stimulus spending will be gradual in the coming years if Biden delivers his second reconciliation bill for FY2022 (Chart 3). Major changes from previous versions have to do with changes to the Congressional Budget Office’s baseline outlook. Our new Democratic Low Spending scenario assumes a $2 trillion dollar green/infrastructure package, a $1 trillion health care reform, and a roughly $2 trillion increase in tax revenue. The Democrats will raise taxes – at least partially repealing Trump’s Tax Cut and Jobs Act and raising a few other taxes. We expect the market to be negatively surprised by the magnitude of tax hikes, at least initially, though the upside risk to the equity market is that tax hikes will be watered down by moderate Democrats in the Senate. We would not bet on a positive tax surprise because even moderate Democrats are in favor of taxing corporations and the wealthy, the taxes can be phased in over a 10-year period, and the economy is on a cyclical upswing combined with mammoth new spending programs. Chart 3US Budget Deficit Booms Under Biden Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our presumption that Biden will sign his second major bill into law this fall (even as late as December) rests on the vulnerability of his administration and party. Traditional Democrats, embodied by Biden, Democratic leaders in Congress, and Biden’s technocratic cabinet (Appendix), face a historic accumulation of political pressure from their populist left-wing and from Trump’s populist Republican Party. If they cannot deliver on major “bread and butter” promises to the American people, while including just enough progressive elements to keep the far left at bay, they risk extinction in coming election cycles. This pressure is real and will enable at least one more major legislative achievement. Bottom Line: Government spending has taken a big step up and Biden’s second major legislative initiative will ensure that the step up is permanent rather than a temporary response to a crisis. The macro impact is inflationary on the margin. Biden’s Second Reconciliation Bill Is the Biden administration over-stimulating the economy and setting the US up for overheating? It looks like it, though the size of tax hikes is as yet unknown. Going forward the stock market will be extremely attentive to two risks that cut in different directions: excessive stimulus and excessive tax hikes. The American Rescue Plan alone is more than twice as large as the estimated output gap. The output gap is widely expected to be closed by the end of the year (Chart 4). Even a $1 trillion infrastructure package – much lower than the currently rumored $3 trillion – would be excessive in this context. Chart 4Output Gap Is Virtually Closed Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The infrastructure package that is being planned – which would include a range of measures in addition to roads and bridges, such as green energy projects, supply chain on-shoring, and digital infrastructure – would take place over a ten-year period and will be coupled with a drag from new taxes. A modern-age infrastructure plan would boost productivity and hence potential GDP growth, which could offset some of the inflationary impact. Speculatively, the simplest path for achieving Biden’s objectives would be to put his health care reform (with other welfare proposals) in the FY2022 reconciliation bill along with tax reform. Tax changes are the purpose of the reconciliation process. Unlike infrastructure, health provisions are virtually guaranteed to pass the arcane rules of reconciliation. This is not a minor concern: the Senate parliamentarian ruled out a federal minimum wage hike in the American Rescue Plan because it was not directly germane to government revenues and expenditures and could do the same to infrastructure. Bear in mind that the Obama administration passed a key component of the Affordable Care Act (Obamacare) via reconciliation, setting a precedent that health care is germane. More broadly the Democratic Party has prioritized health care since 1992, now has a chance to clinch it, and has repeatedly benefited at the ballot box on the health agenda. Infrastructure, unlike health and tax reform, could conceivably pass in a regular bill, or piecemeal in annual spending bills, in which Biden would wheel and deal to try to get 60 votes (50 Democrats, 10 Republicans). However, the latest rumors as we go to press suggest the Democrats will prioritize infrastructure and link it to tax reform. Republicans will not vote for tax hikes so reconciliation would still be required in this case. Reconciliation is trickier with infrastructure spending than with health care, though not impossible. What is clear is that Biden’s agenda is too large to fit into one bill, that tax hikes are being planned, and that reconciliation is necessary for tax hikes. Based on our scenarios in Table 1, every realistic scenario involves an increase to the budget deficit, ranging from around $500 billion to $5.4 trillion over the 10-year period. Therefore the economy will receive additional stimulus on top of the unprecedented peacetime stimulus it has already received. Table 1Scenarios For Biden’s Second Reconciliation Bill Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Two other gleanings from Q1 bear mentioning: Biden’s policies on trade and immigration. On trade, Biden is coopting Trump’s hawkish China policy while trying to improve trade relations with allies and partners. The trade deficit is set to expand along with economic recovery and stimulus, resulting in larger twin deficits (Chart 5). This trend should weigh on the US dollar – but the dollar has strengthened so far this year. Given the US’s inherent strengths – rule of law, innovation, faster relative growth – and the structural rise in global geopolitical tensions, covered regularly by our twin Geopolitical Strategy, we are loathe to bet against a rising dollar. However, investors should note that the BCA House View expects the dollar to relapse and the dollar bear market to continue. On immigration, Biden faces his greatest domestic policy challenge. By easing border and immigration enforcement amid a hyper-charged economic recovery, he has invited a large flow of immigrants and refugees (Chart 6). He is thus forced to take urgent border actions to staunch the flow. If he does what is necessary to maintain order then he will widen the rift with the far left. Meanwhile Republicans are finding an issue over which they can start to reunite. Chart 5US Twin Deficits Balloon US Twin Deficits Balloon US Twin Deficits Balloon Chart 6Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Bottom Line: The air of crisis is dissipating rapidly and proposed tax hikes will motivate opposition but Biden still has enough political capital to get at least one more budget reconciliation bill passed. The bill will focus on health/welfare (easier to pass but more inflationary) or infrastructure (harder but better for productivity). Either way the net deficit impact will be negative and the dual risk of higher taxes and economic overheating will create hurdles for the stock market rally.   Updating Our Three Key Views For 2021 How do the events of Q1 impact our three key views for 2021? At the start of the year we forecast (1) that the US’s political polarization would subside but remain at historically peak levels; (2) that the US would launch major structural reforms, in some cases on a bipartisan basis; (3) that Republican disunity would enable this contradictory environment of polarization yet occasional bipartisanship. Based on the first quarter’s events, we would draw the following conclusions for the second quarter and beyond: 1.   Peak Polarization: Polarization has indeed subsided (Chart 7). The country is still vulnerable to major polarizing events, including domestic extremists of whatever stripe, though any major terrorist attack would likely strengthen support for the sitting government. A fall in polarization is just one positive factor in Biden’s overall political capital, which we measure through our US Political Capital Index (Table 2). We consider Biden’s political capital moderate-to-strong because consumer confidence and the economy will likely improve. However, passing legislation will gradually get harder. The Obama administration had considerably greater strength in the Senate than the Biden administration, though, as mentioned, reconciliation guarantees Biden one or two more major pieces of legislation (Chart 8). Democrats can still overturn the filibuster, which requires a 60-vote majority on regular legislation, as we have long highlighted. But for now they seem to accept a watering-down of the filibuster (a “talking filibuster”) that will still give the minority Republicans the ability to halt controversial legislation. Chart 7Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Table 2Biden’s Political Capital Is Moderate To Strong Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Chart 8Major Legislation Can Pass Early In Presidential Term Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform 2.   Bipartisan Structural Reform: The fact that not a single Republican senator voted for the American Rescue Plan Act, despite the lingering pandemic and air of crisis, suggests that bipartisanship is extremely limited, e.g. limited to the seven Republican senators who voted to convict Trump (Table 3). However, bipartisanship is still possible on an infrastructure package if the Democrats do not link it with tax hikes. Table 3Centrist Senators – And Republicans Who Voted To Convict Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Beneath the surface there is bipartisanship when it comes to trade, supply chains, and countering China. Tariffs bottomed under the Obama administration and Biden started off with another round of “Buy America” provisions and a tentative decision to maintain Trump’s tariffs on China (Chart 9). Measures to boost US supply chain resilience in technology, health, and defense could be rolled up into an infrastructure package to help garner 10 Republican votes. Republicans have prepared for possible compromise by clearing the way for the use of “earmarks,” or constituency-based legislative incentives, otherwise known as pork-barrel spending.  Chart 9Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama The market currently expects an infrastructure bill to pass, as indicated by the outperformance of infrastructure-related stocks, industrials, and materials relative to the market. Our BCA Infrastructure basket is outperforming (Chart 10). The market does not currently expect the Democrats to focus on health care policy, which creates the likelihood of a negative surprise for this sector (Chart 11). Chart 10Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) The managed health care sub-sector (the insurance companies) staged a surprise rally over the past month that should reverse as Biden’s legislative proposals become known. However, Big Pharma and biotech continue to sell off as expected. Again, the simplest FY2022 reconciliation bill would consist of Biden’s health reform plus tax reform. The market is having some doubts about Democrats’ climate change agenda, which will be stuffed into the infrastructure package, given that the US renewable energy index has rolled over relative to global renewables. US cyclicals are also outperforming renewables (Chart 12). If Democrats do not use reconciliation, they may not get many green projects passed. If they do use reconciliation, their health and welfare reforms will have to wait until a FY2023 reconciliation bill that may not get passed. Chart 11More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma Chart 12Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage   3.   Republicans In The Wilderness: Although Republicans have begun to regroup faster than many expected, the divisions within the party have not been healed and will continue to flare up in disputes that threaten to wreck the party. Trump and the populist wing are preparing to put up primary election challengers to establishment Republican senators and representatives who voted against Trump or otherwise who vote against his “America First” agenda. Yet it is possible that 10 Republicans will find it impossible to vote against Biden’s infrastructure package if it is well-designed regarding supply chains and China and not linked with tax hikes. Trump could split the party via his personal following (which may be enhanced by a new social media outlet) and his ability to divide the party’s votes if he forms a “Patriot Party.” We recently showed, via the “Prisoner’s Dilemma” in game theory, that the Republicans must choose a Trumpist agenda of fiscal largesse, trade protectionism, and border security if they are to succeed. Yet Trump may or may not choose to run for president again or form a third party. The result is that Trump is more likely than not to be the Republican candidate in 2024 but there are huge risks to the party’s coherence as the party establishment tries to convince Trump to bow out and support a successor (Diagram 1). The point is that Trump remains a loose cannon and is capable of dividing the party single-handedly. Since investors cannot predict Trump’s behavior they should not expect the Republicans to unite in the near term. Diagram 1Game Theory Says Republicans Will Court Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Bottom Line: Our three key views for 2021 are broadly on track – polarization is subsiding but still near peak levels, structural reform is underway (though bipartisanship is clearly at risk), and the Republicans remain divided and ineffectual. The Democrats’ handling of their infrastructure package will determine if bipartisanship can reinforce structural reform but the FY2022 reconciliation process enables them to achieve some reform regardless. Investment Takeaways The Federal Reserve expects GDP to grow by 6.5% in 2021 as a whole (up from the 4.2% estimate in December) and the unemployment rate to fall to 4.5% by the end of the year (down from 5% previously). Treasury Secretary Janet Yellen is expected to predict full employment by 2022. Households are likely to spend at least a third of the $699 billion in dole money they receive (stimulus checks and topped-up unemployment benefits), according to surveys highlighted by our Global Investment Strategy. This summer will have a party on every block, whether authorized or not. While details are scant about the exact makeup of the Biden administration’s next major legislation, what is clear is that it will have a net negative impact on the budget balance. Democrats will raise taxes but not so much as to jeopardize the economic recovery and their election prospects in 2022-24. This ultra-easy fiscal policy coincides with an ultra-easy monetary policy in which the Fed has insisted it will not raise rates through 2023. The market expects four rate hikes by that time, which would put the Fed funds rate at about 1.1%. The Fed will eventually have to adjust its path for the Fed funds rate and start thinking about thinking about tapering asset purchases. But the main thing to remember is that the Fed has committed to generating an inflation overshoot.   In this context, US investors should be cyclically bullish albeit tactically guarded given the sharp rise in bond yields and rising dollar. A pro-cyclical orientation would favor small caps over large caps, cyclicals over defensives, and value over growth stocks. All of these positions have recently met with some resistance and could face a healthy near-term correction. Cyclical stocks are historically very elevated relative to defensives (Chart 13). But over a 12-month period the recovery and stimulus will reinforce the bullish view, as rising bond yields will not stop equities from rising if the Fed stands pat. Chart 13Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives The chief risks to the pro-cyclical orientation stem from any breakout in the US dollar, the rollover in China’s growth momentum, and the Biden administration’s tax hikes and foreign policy challenges. These risks are all immediate and serious, especially given high stock market valuations. China’s policy tightening will not be fully felt in the economy until the second half of the year and Biden’s specific foreign policy challenges can result in negative geopolitical shocks at any time this year or over the next four years. The point is to buy on the dips unless surprise events fundamentally alter the reflationary cyclical backdrop. With regard to equity sectors, our US Political Risk Matrix highlights the chief policy risks to our US Equity Strategy’s views. Generally speaking Biden poses upside risks to industrials and consumer discretionary sectors and downside risks to energy, health care, tech, and communications (Table 4). After a quarter’s worth of information on markets and policy, these views are mostly confirmed: stay cyclically bullish on industrials and financials, bearish on tech and health care. Table 4US Political Risk Matrix Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform In the case of energy we continue to be neutral-to-bullish over a 12-month time horizon as long as demand is recovering, global inventories are drawing down, and the immediate geopolitical scene is conducive to tit-for-tat attacks in the Middle East, as is the case in the first half of the year. But Biden’s regulatory risks and disruptive climate change agenda can bring negative surprises for US oil producers and Biden’s foreign policy would ultimately be positive for Middle East oil supply. In the case of communications services we are neutral-to-bearish. The Biden administration is allied with Big Tech but it is tightening regulation and anti-trust enforcement gradually to gain greater control over the sector.1 The Treasury selloff is set to continue. Yields are starting to reach pre-COVID levels and have a way to go until they challenge 2018 levels. From peak to trough in the Bloomberg Barclays Treasury Index, the current selloff is not as bad as in the past four recoveries, as our US Bond Strategy has shown. As the economic rebound shows up in hard data over the course of this year, the Fed’s revised expectations will confirm the bond selloff in the financial market. We would thus favor high-yield corporate bonds. We remain overweight TIPS and municipal bonds relative to duration-matched nominal bonds. In recent years presidential approval has correlated remarkably well with the stock-to-bond ratio about two months later (Chart 14). The implication is that higher presidential approval is consistent with receding uncertainty and greater consumer optimism about the economy, which is reflected in rising bond yields and share prices. Neither Biden’s approval rating nor the stock-to-bond ratio is likely to go much higher without a consolidation phase, however, as implied by the chart. Chart 14Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A1BPolitical Capital: Household And Business Sentiment Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform   Table A1CPolitical Capital: The Economy And Markets Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A2Biden’s Cabinet Position Appointments Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Footnotes 1     Biden is expected to nominate anti-trust scholar Lina Khan for FTC commissioner.  

Dear Client, Dhaval Joshi has started publishing the new BCA Research Counterpoint product, in which he will continue to apply his unique process to dig up original investment opportunities around the globe. I trust many of you will continue to read Dhaval’s excellent and thought-provoking work. I also hope to keep your readership as I take the helm of the European Investment Strategy product, where I will apply BCA’s time-tested method which emphasizes analysis of global liquidity and economic trends to forecast European market outcomes. Thank you for your continued trust and support. Best regards, Mathieu Savary   Highlights The Eurozone’s economy lags the US’s because of weakness in the service sector. Poor vaccine rollouts and tighter fiscal policy explain this bifurcated outcome. Even though Europe will continue to trail the US this year, the summer period will see a sharp European recovery. Investors can take advantage of this rebound by buying the cyclical equities that have lagged during last year’s rally. Favor the French, Italian and Spanish equity markets over the German and Dutch markets. The Bank of England does not need to fight rising Gilt yields; favor the pound over the euro as the UK-German spread widens. The Norges Bank will be the first G-10 central bank to lift rates, which will hurt EUR/NOK. Fade any hawkish noise coming from the German election season. Feature The service sector constitutes the biggest drag on the Eurozone’s economy, which will cause European growth to trail that of the US further. The euro area’s fundamental problem is that it lags the US significantly on both vaccination and fiscal stimulus fronts. Nonetheless, by the summer, the European service sector will start catching up, which will favor a basket of sectors exposed to the economic re-opening that have lagged until now. The Service Sector Remains Under The Weather The consensus is correct to expect European growth to lag that of the US in 2021, even if the extent of the shortfall does not hit the 4% currently penciled in by Bloomberg. Chart 1The Service Sector Is the Problem The Service Sector Is the Problem The Service Sector Is the Problem Unlike normal business cycles, the service sector is now Europe’s biggest handicap, while the manufacturing sector is performing in line with that of the US (Chart 1, top panel). On both sides of the Atlantic, industrial activity has benefited from the same set of positives in recent quarters. Goods purchases were the only outlet for pent-up demand built up in the first and second quarter of 2020. Extraordinarily accommodative global liquidity conditions and record-low interest rates boosted spending on big-ticket items, especially in light of the housing boom that has engulfed the globe. Finally, China’s rapid recovery fueled a swift rebound in the demand for natural resources, autos and machinery that benefited manufacturers the world over. Service activity did not enjoy a similar unified tailwind. Consequently, while the US Services PMI stands at a seven-year high, the Eurozone’s lingers at 45.7, in contraction territory (Chart 1, middle panel). The weaker confidence of European households sheds light on this bifurcated performance (Chart 1, bottom panel). Health and fiscal policies are the main headwinds in the Eurozone that have hurt its service sector and hampered the mood of its households, at least compared to the US. With regard to health policy, the poor vaccination rates on the European continent create the greatest problem. The vaccination effort has only reached 11.8, 11.1, 11.9 and 12.5 doses per 100 person in Germany, France, Italy and Spain respectively. In the US and the UK, authorities have already delivered more than 30 doses per 100 person (Chart 2). As a result, while infection and death per capita are rapidly declining in the US and in the UK, mortality is once again rising in France as well as in Italy and caseloads are increasing there and in Germany. Moreover, hospitalization rates and ICU usage in France, Germany, Italy or Portugal are once again trending up, and in some cases they are hitting threatening levels for the healthcare system. In response to these COVID-19 dynamics, governments in many major Eurozone countries are resorting to the re-imposition of restrictions. Italy has announced new lockdowns in half of its 20 regions while France just entered its third lockdown over the weekend. By contrast, the stringency of restrictions is set to ease in the UK and the US. In the US, limitations were already imposed or followed more laxly relative to the euro area (depending on the state) and mobility was improving (Chart 3). Chart 2Slow Vaccination In The Eurozone Slow Vaccination In The Eurozone Slow Vaccination In The Eurozone Chart 3The Stringency Of Lockdowns Matter The Stringency Of Lockdowns Matter The Stringency Of Lockdowns Matter Despite the lower mobility created by stricter restrictions in the Eurozone, the US government has opened the fiscal tap much more aggressively than European governments (Chart 4). Since the beginning of the crisis, the US fiscal help has reached 25% of GDP, while in Italy, Germany, France or Spain the budget deficits have swelled by a more modest 14%, 10%, 9% and 13% of GDP, respectively. True, European governments have also offered credit guarantees totaling EUR3 trillion euros, but these sums only have a very indirect impact on aggregate demand and should mostly be understood as liquidity insurance to prevent a liquidity crisis from morphing into a solvency crisis. Chart 4Tight Fists On The Continent Summer Of ‘21 Summer Of ‘21 For the remainder of 2021, European fiscal policy is unlikely to be eased compared to the US. BCA Research’s Geopolitical strategy team anticipates the Biden government to add a further $2 trillion dollars of spending by the end of 2021, mostly in the form of long-term and infrastructure outlays, in addition to the $1.9 trillion recently legislated.While the European Union’s NGEU plan is an important step in the integration of European fiscal policy, its generous EUR750 billion envelope will be disbursed over five years. This implies a debt-based fiscal expansion of 1% per annum between 2021 and 2024 (the years of maximum disbursements). Individual state plans are also limited. Bottom Line: The European economy is lagging the US economy because of the inferior performance of its service sector. This disadvantage is the consequence of both a slower vaccine rollout that is negatively impacting mobility and a much more timid fiscal policy. Relief Is On Its Way The Eurozone’s service sector and domestic economic performance is nonetheless set to improve, despite the current health and fiscal policy deficiencies. First, the economy continues to adapt to its new socially distanced form. In the second quarter of 2020, the imposition of lockdowns caused the euro area’s quarterly GDP to collapse by 11%. The contribution to GDP of the retail, wholesale, artistic, entertainment, and hospitality sectors tumbled to -7.3%. In Q4 2020, as European governments were imposing equally stringent lockdowns, quarterly GDP growth fell to -0.1% and the contribution to growth of the same sectors only hit -0.54%. Second, the continental vaccination campaign is progressing. It is easy to worry that it will take a very long time to vaccinate the entire population, but the main reason to impose lockdowns is to preserve capacity in the healthcare system. Thus, the priority is to inoculate 50-year olds and above because they constitute 90% of hospitalizations. Through this aperture, even if the pace of vaccination remains tepid in Europe, the goal to decrease economic restrictions can reasonably be achieved by summer. Moreover, with Pfizer’s logistical issues corrected, the pace of vaccination can accelerate. Concerns remain over the population’s willingness to receive the vaccines, but these issues will fade as well. The current worries surrounding the AstraZeneca vaccines provide an example. The incidence of thromboembolic events is marginally higher than for the general population and the European Medicines Agency deemed the AstraZeneca vaccines safe, especially in light of the human costs of the disease it prevents. As caseloads and mortality rates decline in Israel, the UK and the US, even French elderlies will become more willing to receive their vaccines. Table 1Parsimonious But Constant Fiscal Stimulus… Summer Of ‘21 Summer Of ‘21 Third, fiscal policy will remain easy. True, European government support is tepid compared to the US, but the continual drip of new policy measures shows that authorities are not intransigent (Table 1). In all likelihood, the various furlough and employment protection schemes implemented since the spring of 2020 are likely to remain in place this year even if lockdowns decrease. Their impact on employment was major and they contributed meaningfully to preserve household income (Chart 5). Finally, COVID-19 is a seasonal illness and summer is on its way in Europe. The experience of 2020, when vaccines and testing were much more limited than they are today, has taught us that in the summer months, this coronavirus spreads much less. Therefore, seasonal patterns will allow a relaxation of social distancing measures. Chart 5Furloughs Played A Crucial Role Summer Of ‘21 Summer Of ‘21 In this context, service activity in the Eurozone will improve, which will boost GDP. European households, like their US counterparts, have accumulated significant excess savings (Chart 6). Furthermore, global manufacturing activity will remain robust, which will support employment and household income in the Eurozone. Hence, consumer confidence will improve and some of the EUR300 billion in excess savings will make its way into the economy. The service sector should be the prime beneficiary of this money because households have already fulfilled a large proportion of their pent-up demand for goods. What they now want to do is to go out, go to restaurants and spend their income on experiences. The rebound in the contribution to GDP of the retail and recreation sectors will be accretive to job and household income, unleashing a virtuous circle of activity (Chart 7). Chart 6European Are Building Their Nest Egg too European Are Building Their Nest Egg too European Are Building Their Nest Egg too Chart 7Services Will Contribute Again to Growth Services Will Contribute Again to Growth Services Will Contribute Again to Growth Bottom Line: In 2021, the euro area’s economy will further lag that of the US, but investors should nonetheless expect a robust uptick in service activity this summer. How To Play The Summer Recovery? Chart 8Buy The Laggards / Sell the Leaders Summer Of ‘21 Summer Of ‘21 Five weeks ago, BCA Research’s US Equity Sector Strategy service designed a strategy to buy the laggards within a basket of sectors that should benefit from the recovery while selling the “back-to-work” stocks that had already priced in that recovery.  This recommendation protects investors against potential hiccups in the re-opening trade and is simple to implement: sell/underweight the pro-cyclical sectors that stand above their February 19 relative peak and buy/overweight those that remain below their relative highs (Chart 8). In the Eurozone context, this strategy involves focusing on the cyclical sectors, and buying/overweighting these cyclical stocks that stand below their pre-COVID high relative to the MSCI benchmark while selling/underweighting those that have punched above this threshold. Chart 9 illustrates the sectors to favor and the ones to avoid using this methodology. In essence, not only should the “laggards” baskets experience a catch up in earnings, but also, the shift in sentiment should prompt a re-rating of relative valuations (Chart 10). Chart 9Who Are the Laggards And the Leaders? Summer Of ‘21 Summer Of ‘21 This strategy makes sense beyond the COVID-19 dynamics. From a global perspective, the basket of sectors purchased (the laggards”) outperforms the former “leaders” after global bond yields increase (Chart 11, top panel). This relationship reflects the heavy representation of financials in the “laggards” basket while tech and the interest rates-sensitive automobile sector are key constituents of the “leaders” basket. Additionally, the former “leaders” are more exposed to the Chinese business cycle than the “laggards". Chart 10Relative Valuations will Adjust Relative Valuations will Adjust Relative Valuations will Adjust Chart 11Macro Forces Favor The Laggards over the Leaders Macro Forces Favor The Laggards over the Leaders Macro Forces Favor The Laggards over the Leaders The deceleration in the Chinese economy is a problem for the “leaders” relative performance (Chart 11, bottom panel). China’s credit impulse has rolled over as Beijing aims to prevent excess speculation in the real estate sector. Moreover, a regulatory tightening is taking place in the Middle Kingdom, which will further slow its economy. Already, the new orders-to-inventories ratio from the NBS PMI reflects the downside risk for the Chinese economy, which highlights the threat to the previous high-flying leaders. A strategy that favors the former “laggards” at the expense of the previous “leaders” also has implications for geographical allocation within euro area equities. As Table 2 shows, Italy, France and Spain over represent the “laggards” in their national benchmarks while the Netherlands and Germany overweight the “leaders”. On a net basis, the tech-heavy Netherlands is the country to avoid, with a 27% relative underweight for the “laggards”, while Spain and Italy should be favored, with their 24% and 22% overweight in the “laggards” relative to the “leaders”. Spain and Italy in particular will also benefit from a further narrowing in sovereign spreads that will boost the performance of their financial sector while the re-opening of trade continues. Additionally, investors should favor France at the expense of Germany. Table 2France, Italy, and Spain Over The Netherlands And Germany Summer Of ‘21 Summer Of ‘21 Bottom Line: The economic re-opening favors the Eurozone cyclicals that still trade below their February 19 2020 relative highs as the expense of those cyclicals that have already overtaken their pre-COVID peaks. This means buying/overweighting the Banks, Insurance, Energy and Aerospace & Defense sectors at the expense of the IT, Automobiles and Building products sectors. It also implies a preference for Italian and Spanish equities, especially relative to Dutch equities. Country Focus: The BoE Follows the Fed, Not The ECB Last Thursday, the Bank of England followed in the Fed’s footprints, not the ECB’s. The BoE refrained from adding to its asset purchases, even if this year, 10-year Gilt yields are rising in line with the Treasuries and rapidly outpacing Bund yields. However, the BoE remains committed to keeping short rates at record lows and it keeps the window open for rate cuts if economic conditions ever warrant it. We agree with the Bank of England that the UK’s economic outlook has improved in recent months. The extension of both the furlough schemes and tax holidays, along with the rapid pace of vaccination in the British Islands point to robust growth in the coming quarters. Nonetheless, the picture is not without blemish. Specifically, the UK’s exports to the EU are collapsing in wake of Brexit. Moreover, the pace of vaccination in the UK is set to slow a bit over the coming months. These risks to the outlook are unlikely to topple the economy, because the vigor of the UK’s housing market is an important support to domestic demand. While the UK’s labor market remains frail, the strength of the RICS housing survey suggests that real wages will stay well bid (Chart 12). The increase in household income will cause consumption to accelerate sharply once lockdowns are eased. This could accentuate inflationary pressures this year, and cause inflation over the next few years to trend higher relative to the euro area. Chart 12UK Real Wages Have Upside UK Real Wages Have Upside UK Real Wages Have Upside With this economic backdrop, the market’s pricing of the SONIA curve is appropriate. Over the past month, the OIS curve has steepened significantly (Chart 13). The BoE is comfortable with that pricing and considers the back up in interest rates to be reflective of stronger growth and not constraining of activity. In fact, financial conditions are roughly unchanged since the MPC’s last meeting, which highlights that rising risk asset prices have compensated for an appreciating pound and rising gilt yields. Chart 13SONIA Is Climbing Up, And The BoE Is Fine With It SONIA Is Climbing Up, And The BoE Is Fine With It SONIA Is Climbing Up, And The BoE Is Fine With It Bottom Line: The SONIA curve will continue to shift higher relative to the EONIA curve. Consequently, the spread between Gilt and Bund yields will widen further and EUR/GBP will depreciate more over the coming six to nine months, especially because the pound keeps trading at a discount. Moreover, thanks to their domestic focus and lower sensitivity to the pound, UK mid-cap and small-cap stocks will outperform the FTSE-100. Country Focus: Norges Bank, First Out Of The Gate Chart 14The Norges Bank Will Raise Rates First The Norges Bank Will Raise Rates First The Norges Bank Will Raise Rates First Last Thursday, Governor Øystein Olsen indicated that the Norges Bank would increase interest rates from zero later this year, which validates the message of the Norwegian swap curve. Looking at economic fundamentals, investors should not bet against this outcome. BCA’s Central Bank Monitor confirms that the Norges Bank will be the first central bank in the West to lift interest rates (Chart 14). It is the only one of our Monitors in “Tight Money Required” territory. The message from our Norges Bank Monitor reflects the prompt recovery of the Norwegian economy. Thanks to rebounding Brent prices and rapidly expanding production at the new Johan Sverdrup oil field (the largest in the North Sea), Norwegian nominal exports are growing at a double-digit pace. Meanwhile Norwegian retail sales are increasing at a 16% annual rate. Beyond some near-term COVID worries, consumer spending will remain robust because the strong employment component of the PMI points to solid job gains and a rapidly rising consumer confidence. Finally, Norwegian inflation is already above the central bank’s target of 2%, with core CPI at 2.05% and headline inflation at 3.3%. Chart 15A Weaker EUR/NOK ahead A Weaker EUR/NOK ahead A Weaker EUR/NOK ahead Thanks to Norway’s economic performance, the krone remains one of the favorite currencies of BCA’s Foreign Exchange Strategy service.  The global economic environment creates additional tailwind for the NOK. A continued global economic recovery will allow oil prices to rise further on a 12- to 18-month basis, which should lead to a weaker EUR/NOK (Chart 15). In a similar vein, the NOK is particularly sensitive to the USD dollar’s fluctuations. As a result, BCA’s negative cyclical stance toward the USD will create an important support for the NOK, even if the greenback’s countertrend bounce could last another quarter or so. Finally, along with the SEK, the NOK is the cheapest pro-cyclical currency in the G10, trading at a 5% discount to its fair value. Thus, the Norwegian krone should benefit greatly from continued risk taking this year. Bottom Line: The Norwegian krone remains one of the most attractive currencies in the world. The status of the Norges Bank as the front-runner to lift rates this year only amplifies the NOK’s appeal. A Few Words On Germany’s State Elections Chart 16German Party Polling German Party Polling German Party Polling The defeat of Angela Merkel’s CDU party in the states of Baden-Wurttemberg and Rhineland-Palatinate highlights that the German electorate is moving slowly to the left. According to BCA’s Geopolitical Strategy Service, it is too early to tell whether a left-wing coalition will take power in Germany this fall. However, the marginal shift toward the SPD and the Green Party indicates that even the CDU will have to listen to the median voter’s demands (Chart 16).  Practically, this means that German politics will push for more European integration and that ultimately, more fiscal stimulus will materialize in Europe over the coming years. As a result, investors should fade any hit to the euro or European assets caused by hawkish sounds made by CDU potential leaders during the campaign for the September federal election.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Closed Trades Currency Performance Summer Of ‘21 Summer Of ‘21 Fixed Income Performance Government Bonds Summer Of ‘21 Summer Of ‘21 Corporate Bonds Summer Of ‘21 Summer Of ‘21 Equity Performance Major Stock Indices Summer Of ‘21 Summer Of ‘21 Geographic Performance Summer Of ‘21 Summer Of ‘21 Sector Performance Summer Of ‘21 Summer Of ‘21  

Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 1Biden’s Tax Hike Proposals On The Campaign Trail Building Back … The Wall Of Worry Building Back … The Wall Of Worry Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) Building Back … The Wall Of Worry Building Back … The Wall Of Worry For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening Building Back … The Wall Of Worry Building Back … The Wall Of Worry The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark China Policy Overtightening Benchmark China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge Building Back … The Wall Of Worry Building Back … The Wall Of Worry China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China Building Back … The Wall Of Worry Building Back … The Wall Of Worry The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China EU Risk Averse On China EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce Building Back … The Wall Of Worry Building Back … The Wall Of Worry As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 4BGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling German Party Polling German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Building Back … The Wall Of Worry Building Back … The Wall Of Worry Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.

Highlights Stimulus checks will not be inflationary. Most households will regard them as additional wealth, and the propensity to spend additional wealth is very low. The bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The bond market’s expectations for inflation are positively correlated with commodity prices, whereas actual prospective inflation is negatively correlated with commodity prices. When, as now, the crude oil price is above $50, long-term investors should overweight T-bonds versus Treasury Inflation Protected Securities (TIPS). The real bond yield is much higher than the bond market is pricing, which means that equities and other risk-assets are more expensive than they appear. Fractal trades shortlist: stocks versus bonds, 30-year T-bond, NOK/PLN. Feature Chart of the WeekCrude Oil Above $50 Results In Prospective Deflation Crude Oil Above $50 Results In Prospective Deflation Crude Oil Above $50 Results In Prospective Deflation Major anomalies should not exist in the financial markets, and least of all in the government bond market which is supposed to be the most efficient market of all. But a major anomaly does exist. The anomaly is in the way that the bond market prices inflation. More about that in a moment, but let’s first discuss whether the current surge in inflation expectations is warranted. The Inflationary Impact Of Stimulus Checks Is Exaggerated Inflation expectations have risen. And they have risen especially in the US, for two reasons. First, compared with Europe, the US vaccination roll-out appears to be going relatively smoothly. Second, the US government has been more pro-active in stimulating the economy, especially in the form of issuing stimulus checks to households, as well as other so-called ‘personal current transfer payments.’ Given that this has boosted incomes while spending has been constrained, the US household sector has amassed a war chest of savings. The argument goes that as social restrictions and voluntary social distancing are eased, this war chest will get spent, unleashing a tsunami of pent-up demand which will drive up inflation. But is this argument correct? Even if social restrictions do fully ease – a big if – is it correct to assume that unspent income will get spent? A recent study by the Bank of England points out that whether unspent income gets spent depends on whether households regard it as additional income or additional wealth.1 Whether unspent income gets spent depends on whether households regard it as additional income or additional wealth. The propensity to consume out of additional income is relatively high, with estimates ranging up to 50 percent. But the propensity to consume out of additional wealth is tiny, with international estimates centred around just 5 percent. This begs the question: will households regard the stimulus checks as additional income or additional wealth? The answer depends on whether the household has a low income or a high income. Lower income households, that have borne the brunt of job losses and furloughs, have suffered big drops in their income relative to consumption. Hence, they will regard the stimulus checks as additional income. But to the extent that the additional income is just (partly) replacing lost income, it will not boost their consumption versus what it would have been absent the lost income. On the other hand, higher income households and retirees have largely maintained their incomes while their consumption has fallen. This is where the surge in savings is concentrated. But not being ‘income or liquidity constrained’, these higher income households are more likely to deposit the stimulus checks into their savings accounts (or the stock market), regarding it as additional wealth. Hence, any boost to consumption will be modest and short-lived. In fact, this was precisely what happened after previous issues of stimulus checks, such as in 2008 and 2009. Stimulus checks had no meaningful impact on consumption or inflation trends (Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends Stimulus Checks Had No Meaningful Impact On Consumption Or Inflation Trends A Major Anomaly In The Bond Market The recent surge in inflation expectations has moved in perfect lockstep with higher prices for commodities, especially crude oil. At first glance, this relationship seems intuitive. After all, we associate higher commodity prices with higher inflation. But on further thought, the tight positive correlation between inflation expectations and commodity price levels is counterintuitive. The first issue is basic maths. Inflation is a change in a price, so it should not move in lockstep with the level of any price. But there is a much bigger issue. Whether the commodity price is driving inflation expectations or whether inflation expectations are driving the commodity price, a higher price today will feed back into lower prospective inflation. In fact, a crude oil price above $50 has consistently predicted prospective deflation in the oil price, leading to CPI inflation underperforming its 2 percent target (Chart of the Week). The bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The important takeaway is that the bond market’s model for predicting inflation is the precise opposite of what happens in the real world. The bond market’s expectations for inflation are positively correlated with commodity prices, but actual prospective inflation is negatively correlated with commodity prices (Chart I-3 and Chart I-4). Chart I-3The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... The Bond Market's Expectations For Inflation Are Positively Correlated With Commodity Prices... Chart I-4...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices ...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices ...But Actual Prospective Inflation Is Negatively Correlated With Commodity Prices This major anomaly in the bond market creates a great opportunity for long-term bond investors. When the (Brent) crude oil price is above $50, long-term investors should overweight T-bonds versus Treasury Inflation Protected Securities (TIPS). And vice-versa when crude falls below $50. With Brent now at $68, the appropriate long-term stance is to overweight T-bonds versus TIPS (Chart I-5). Chart I-5When The (Brent) Oil Price Is Above , Long-Term Investors Should Overweight T-bonds Versus TIPS When The (Brent) Oil Price Is Above $50, Long-Term Investors Should Overweight T-bonds Versus TIPS When The (Brent) Oil Price Is Above $50, Long-Term Investors Should Overweight T-bonds Versus TIPS There are also implications for other investors. Given that the bond market is useless at predicting inflation, it is also useless at assessing real interest rates. Specifically, when crude is above $50, the ex-post (realised) real bond yield will be higher than the ex-ante (assumed) real bond yield (Chart I-6). The important takeaway right now is that in any comparison with the real bond yield, equities and other risk-assets are even more expensive than they appear. Chart I-6When The (Brent) Oil Price Is Above , The Realised Real Bond Yield Will Be Higher Than Assumed When The (Brent) Oil Price Is Above $50, The Realised Real Bond Yield Will Be Higher Than Assumed When The (Brent) Oil Price Is Above $50, The Realised Real Bond Yield Will Be Higher Than Assumed Embrace The Fractal Market Hypothesis The Fractal Market Hypothesis (FMH) is a breakthrough in the understanding of financial markets, replacing the defunct Efficient Market Hypothesis (EMH). The breakthrough insight from the Fractal Market Hypothesis is that the market is not always efficient. The market is efficient only when a wide spectrum of investment time horizons is setting the price, signified by the market having a rich fractal structure. The Fractal Market Hypothesis (FMH) is a breakthrough in the understanding of financial markets. The corollary is that when the fractal structure becomes extremely fragile, it tells us that the information and interpretation of long-term investors is missing from the recent price setting, and is likely to reappear. At which point, the most recent price trend, fuelled by short-term groupthink, will break down. As most investors are unaware of the Fractal Market Hypothesis, it gives a competitive advantage to the few investors that do embrace it. Through the past five years, our proprietary Fractal Trading System has identified countertrend trading opportunities with truly excellent results. After 207 trades, the ‘win ratio’ stands at 61 percent. Yet as we understand more about this breakthrough theory of finance, we believe we can do even better. Today, we are very pleased to upgrade the trading system with innovations to the calculations of fractal structure, the countertrend profit opportunity, and the optimal holding period, all detailed in Box I-1. Box 1: Fractal Trading System Principles Countertrend opportunities in an investment will be identified by a fragile composite fractal structure, based on 65-day, 130-day, and 260-day fractal dimensions approaching their lower bounds. The countertrend profit target will be based on a Fibonacci retracement. There will be a symmetrical stop-loss. The maximum holding period will be trade-specific and vary from 33 to 130 business days (broadly 6 weeks to 6 months). From today, we will also identify a larger number of fragile fractal structures and especially highlight those that are evident in mainstream investments. From this shortlist of candidates, we will choose the most compelling to add into our portfolio. In many cases, the alignment of a fundamental argument with a fragile fractal structure will reinforce the investment case. Among our most recent recommendations, underweight China versus New Zealand achieved its 9 percent target, short Korean won versus US dollar achieved its 2.5 percent target, and long Russian rouble versus South African rand expired at 1.5 percent profit. This week, we highlight that the composite fractal structures of stocks versus bonds and the 30-year T-bond are becoming extremely fragile (Chart I-7 and Chart I-8). To be clear, this does not guarantee a countertrend move, but it does indicate an elevated susceptibility to a countertrend move. Hence, for the time being, we remain tactically neutral stocks versus bonds.  Chart I-7The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile The Fractal Structure Of Stocks Versus Bonds Is Becoming Fragile Chart I-8The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile The Fractal Structure Of The 30-Year T-Bond Is Becoming Fragile In the foreign exchange markets, we note that the strong advance in the Norwegian krone, fuelled by the rally in crude oil, is vulnerable to a pullback (Chart I-9). Accordingly, this week’s recommended trade is short NOK/PLN, setting a profit target and symmetrical stop at 2.6 percent. Chart I-9Short NOK/PLN NOK/PLN NOK/PLN   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Bank of England, An update on the economic outlook by Gertjan Vlieghe, 22 February 2021 Fractal Trading System A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Asset Performance A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Equity Market Performance A Major Anomaly In The Bond Market A Major Anomaly In The Bond Market Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The breadth of EM equity outperformance versus DM in H2 last year was poor. This outperformance was largely driven by EM TMT stocks. These EM TMT share prices are now facing challenges and are unlikely to provide leadership for the EM equity index going forward. Meanwhile, the fundamental backdrop of EM ex-TMT equities remains poor. Hence, the EM equity index will for now be in limbo. Feature Over the past year, the EM stock index has done very well in absolute terms and has slightly outperformed the global equity index. Yet, its relative outperformance versus the global equity benchmark has been largely due to TMT (technology, internet and catalog retail, and media and entertainment) stocks.1 The top panel of Chart 1 reveals that EM non-TMT stocks have not really outperformed their global peers. In contrast, EM TMT share prices had considerably outpaced their global counterparts until mid-February (Chart 1, bottom panel). However, odds are that EM TMT share prices will weaken both in absolute terms and relative to global TMT stocks (more on this below). The market-cap weight of EM TMT stocks in the EM MSCI equity benchmark has surged and it presently stands at 41%. This number is 42% for the US, 16% for the euro area and 17% for Japan. Until January, relative outperformance of US and EM stocks versus the global benchmark had been largely due to the outperformance of TMT stocks and their overwhelming weights in the US and EM equity indexes. Further, the EM equal-weight and small-cap stock indexes have failed to outperform their global peers, confirming the lack of breadth in EM outperformance (Chart 2). In brief, the EM stock index has by and large been a one-trick pony. Chart 1EM Outperformance Versus Global Has Been Entirely Due To TMT Stocks EM Outperformance Versus Global Has Been Entirely Due To TMT Stocks EM Outperformance Versus Global Has Been Entirely Due To TMT Stocks Chart 2EM Equal-Weighted And Small Caps Have Not Outperformed EM Equal-Weighted And Small Caps Have Not Outperformed EM Equal-Weighted And Small Caps Have Not Outperformed   Can the EM equity index both rally in absolute terms and outperform DM stocks if its leaders – TMT companies – encounter challenges? We do not think so. The basis is that fundamentals outside TMT stocks remain lackluster. EM TMT Stocks There are a few reasons why EM TMT stocks will stay under selling pressure: Chart 3TMT Stocks Are Over-Extended TMT Stocks Are Over-Extended TMT Stocks Are Over-Extended The overwhelming headwind for EM TMT stocks is the regulatory crackdown on platform companies in China. Alibaba and Tencent together make up 30% and 11.5% of the MSCI Chinese Investable and MSCI EM equity benchmarks, respectively. Regulatory pressures on them has been growing since October. The recent speech by President Xi implies that the regulatory clampdown is not over. We wrote about how antitrust regulation can affect share prices of these Chinese conglomerates in our November 26 report. US FAANGM stocks as well as Tencent have surged by more than 20-fold since early 2010. That is as much as the Nasdaq100 index during the 1990s (Chart 3). Alibaba and Meituan were listed in 2014 and 2018 respectively so they do not have a ten-year history. We are not suggesting that the share prices of Chinese platform companies will drop by 70% - as much as the Nasdaq 100 index did post its 2000 crest. Our point is that valuation excesses and overbought conditions in Chinese TMT stocks present material downside risk to their share prices when faced with the regulatory clampdown. In addition, rising US bond yields will continue to hurt high-multiples stocks around the world, which include EM TMT stocks, as we discussed in the February 25 Special Report. Technology companies TSMC and Samsung make up 6.6% and 4.3% of the MSCI EM benchmark, respectively. Their valuations are also lofty. Besides, local retail investors played a large role in rallies in both markets last year (Chart 4). It is hard to predict retail investor behavior, but last year’s stampede into stocks could give way to a period of retrenchment. There is another sign of a top for the EM technology and consumer discretionary stocks (Alibaba and Meituan together make 40% of the EM consumer discretionary market cap). Both EM technology (primarily semiconductors) and EM consumer discretionary (internet and catalog retail as well as autos) each make up 20% of the EM benchmark market cap – a threshold that often marks a major peak in their share prices (Chart 5). Chart 4Retail Investors Have Been Driving Korean And Taiwanese Share Prices Retail Investors Have Been Driving Korean And Taiwanese Share Prices Retail Investors Have Been Driving Korean And Taiwanese Share Prices Chart 5EM Sectors Peak When They Reach 20% Of EM Benchmark EM Sectors Peak When They Reach 20% Of EM Benchmark EM Sectors Peak When They Reach 20% Of EM Benchmark   Historically, when the market cap of an EM equity sector reached 20% of the EM MSCI equity benchmark, that marked an apex of its absolute and relative outperformance. This was the case with EM banks in 2013, energy stocks in 2008, and technology in 2000. Within TMT stocks, dedicated EM equity portfolios should favor semiconductor producers versus platform companies. Semiconductor stocks are less expensive and their booming revenues will limit downside in their share prices (Chart 6). Bottom Line: The poor risk-reward profile of TMT stocks implies that the emerging Asian equity benchmark has for now passed the zenith of its relative outperformance against global stocks (Chart 7). Chart 6Asian Semiconductor Companies' Revenues Are Still Booming Asian Semiconductor Companies' Revenues Are Still Booming Asian Semiconductor Companies' Revenues Are Still Booming Chart 7Emerging Asian Stocks Versus Global: A Period Of Underperformance Ahead Emerging Asian Stocks Versus Global: A Period Of Underperformance Ahead Emerging Asian Stocks Versus Global: A Period Of Underperformance Ahead   Beyond TMT The poor performance of non-TMT stocks has not been limited to the Latin America and EMEA bourses. Emerging Asian non-TMT stocks have also not outperformed their global peers. Chart 8No Bull Market In EM And China ex-TMT Stocks No Bull Market In EM And China ex-TMT Stocks No Bull Market In EM And China ex-TMT Stocks Notably, in absolute terms EM ex-TMT share prices remain below their peak in 2018 (Chart 8, top panel). Besides, Chinese investable non-TMT stocks have not broken out of the trading range that has been in place since 2011 (Chart 8, bottom panel). The following will continue weighing on EM non-TMT stocks: The recovery in many EM economies outside North Asia has been lackluster. Household consumption and capital spending in EM (ex-China, Korea and Taiwan) have been much more subdued than those in the US. These countries are substantially lagging DM economies in vaccinations, delaying the economic normalization and warranting continued economic underperformance. Many EM economies outside North Asia are facing a negative fiscal thrust this year. Their banking systems remain saddled with NPLs and are reluctant to lend. The underperformance of EM (ex-China, Korea, Taiwan) bank stocks versus their global peers corroborates the notion that the monetary transmission mechanism is broken in many of these economies. Without recovery in bank credit, domestic demand will remain lackluster. Rising US bond yields have caused EM (ex-North Asia) local bond yields to spike and currencies to weaken (Chart 9). We expect more upside in US Treasury yields and a  relapse in EM exchange rates. This is bad for their stock markets. Critically, the Chinese economy is now facing triple tightening and its growth will weaken in H2 2021: 1. Monetary and fiscal tightening: The credit and broad money (M3) impulses have already rolled over (Chart 10, top panel). Fiscal policy will also tighten relative to the unprecedented stimulus of last year. This represents a major risk to industrial metals that are very overbought (Chart 10, bottom panel). Chart 9EM (ex-China, Korea And Taiwan): Currencies, Rates And Stocks EM (ex-China, Korea And Taiwan): Currencies, Rates And Stocks EM (ex-China, Korea And Taiwan): Currencies, Rates And Stocks Chart 10Peak Stimulus In China Peak Stimulus In China Peak Stimulus In China   The relapse in Taiwanese new orders of basic materials PMI heralds weakness in Chinese material stocks (Chart 11). 2. Regulatory tightening on banks and non-bank financial institutions: Authorities are planning to reinforce asset management regulation by the end of this year. This will limit how much these financial institutions can expand their balance sheets reinforcing a credit slowdown. 3. Property market tightening: Restrictions on both property purchases and property developers’ leverage will lead to a notable slump in real estate construction. Property stocks have formed a tapering wedge and a breakdown is likely (Chart 12, top panel). Besides, their off-shore corporate bond prices are gapping down (Chart 12, middle panel). Chart 11An Apex In Chinese Material Stocks An Apex In Chinese Material Stocks An Apex In Chinese Material Stocks Chart 12Chinese Property Sector Is At Risk Chinese Property Sector Is At Risk Chinese Property Sector Is At Risk   Overall, Beijing’s ongoing policy tightening and resulting economic slowdown will weigh on China ex-TMT stocks that are dominated by banks and old-economy companies. Crucially, onshore small cap stocks have already relapsed suggesting that economic weakness might be broad-based (Chart 12, bottom panel). Bottom Line: Even though EM ex-TMT stocks offer reasonable multiples, their fundamentals remain unexciting. A Review Of Some Of Our Equity Recommendations Chart 13EM Versus Global: Relative Equity Performance EM Versus Global: Relative Equity Performance EM Versus Global: Relative Equity Performance 1. We recommend maintaining a neutral allocation to EM stocks in a global equity portfolio. EM relative performance will fluctuate but is likely to stay within a trading range between last May’s low and the recent highs (Chart 13). In regard to other regions, Europe and Japan should outperform the US as global value continues to outperform global growth in next 6-12 months. 2. Long global value / short Chinese investable value stocks. Global value will benefit from the reopening of economies in the US and Europe. Financials, which hold a large weight in the global value index, will be supported by rising global bond yields. Given that multiples on the value stocks are lower than growth stocks, rising bond yields will cause less damage to value stocks. Chinese investable value stocks are heavy in banks. The latter will suffer the consequences of  the credit boom and capital misallocation in China. In a recent special report on China, we estimated that mainland banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In short, Chinese banks have dealt with only 10% of all loans originated since 2009, which is a small number given the magnitude and duration of this credit boom. Hence, we reckon that banks remain saddled with a large amount of NPLs that have not been provisioned for. Outside banks, Chinese investable value stocks will be at risk of ongoing triple policy tightening in China, as discussed above. Chart 14Long Chinese A Shares / Short Chinese Investable Index Long Chinese A Shares / Short Chinese Investable Index Long Chinese A Shares / Short Chinese Investable Index 3. Long Chinese A shares / short Chinese investable equity index (Chart 14). We recommended this strategy in a March 4 report discussing China’s structural strengths and weaknesses. The primary reason for this recommendation is that the A-share index2  is heavy in value stocks while the MSCI China investable index has a large weight in expensive new economy stocks. The global investment backdrop has shifted in favor of global value versus global growth stocks due to strong US growth and rising US bond yields. Hence, this strategy is consistent with our preference for global value over global growth stocks. Finally, this strategy will benefit from regulatory tightening on platform companies that have a large weight in the Investable index. Chart 15Favor Global Industrials Over Global Materials Favor Global Industrials Over Global Materials Favor Global Industrials Over Global Materials 4. We have strong conviction that global growth stocks will underperform global value but less conviction that EM growth will underperform EM value. The reasons are as follows: EM value is dominated by EM banks. Not only will Chinese banks suffer from the problems discussed above but also EM ex-China banks are facing many cyclical and structural challenges. Hence, they will benefit less than DM banks from rising bond yields. The EM value index has also considerable weight in energy and material stocks and is light on industrial equities compared to the DM value index. China’s tightening and the ensuing growth slowdown in H2 2021 will weigh more on global materials than on global industrials. Materials are very exposed to China’s construction and infrastructure. China accounts for about 55% of the world’s industrial metals consumption while the US accounts for 7-9%. By contrast, global industrial share prices are more diversified and Chinese demand does not dominate industrial goods to the same extent that it does with industrial metals. Therefore, strong growth in US and European demand and the impending slowdown in China favors global industrial stocks versus global materials. Industrial companies have a larger weight in the DM value index than in the EM value index. By contrast, the materials equity sector has a larger market cap share in the EM value index than in the global value index. In short, investors should favor global industrials versus global materials (Chart 15) over the coming 6-to-12 months and that leads us to have high conviction on the DM value index’s outperformance versus the EM value index. Finally, rising US bond yields will pressure US growth stocks that are heavy in platform companies/new economy stocks. The EM growth index has a large weight in semiconductor producers in Korea and Taiwan that have a better long-term outlook than platform companies. The basis is that TSMC and Samsung have technological advantages over their global peers in producing new, high-performance chips. Such technological advantages give them pricing power in addition to a solid volume expansion. While these Asian semiconductor stocks are very overbought and will likely correct along with global growth stocks, their long-term outlook is positive, and is superior to EM value plays. That is why we have a high conviction view on the underperformance of DM growth stocks relative to DM value ones, but have low conviction on the performance of EM growth versus EM value. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 A TMT stock index refers to a market cap-weighted average of share prices of technology, internet and catalog retail, and media and entertainment. 2 Please note that this is a call for Shanghai- and Shenzhen-listed A shares not the CSI300 index which has a large weight in expensive growth stocks. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The American Rescue Plan Act confirms the shift to “Big Government” and proactive fiscal policy in US politics. This sea change in policy is durable for now, given that Democrats can pass one or two more budget reconciliation bills without a Republican vote. Details of forthcoming tax hikes are starting to leak from Washington. Investors should not assume that progressive proposals like a wealth tax, a financial transactions tax, or a minimum corporate tax are dead on arrival. Taxing corporations and the rich is popular. The Republican Party is likely to choose a Trumpian agenda going forward and Trump has a good chance of being the presidential candidate in 2024. But cyclical and structural factors disfavor Republicans at this early stage. Industrials have rallied sharply in advance of Biden’s first law and are now overbought. But we would favor them over health care over a 12-month period, given the macro backdrop and relative policy risks. Feature Were there any surprises in the American Rescue Plan Act (ARPA) signed by President Biden on March 11? Only that some of Biden’s health care and infrastructure agenda slipped into the bill, alongside a provision holding that if states cut taxes and lose revenue, they will lose an equivalent amount in state and local aid. The plan illustrates that the budget reconciliation process is an effective tool for the ruling party to get most of what it wants. The Biden administration will be able to pass one or two more reconciliation bills for FY2022 and FY2023. While the next bills will be harder to pass than the first, and moderate Democratic senators will limit Congress’s options somewhat, the point is that Democrats have just enough political capital to achieve their policy agenda without a single Republican vote. As always, our Political Capital Index is updated in the Appendix and highlights falling political polarization and improving business sentiment, which is positive for Biden’s political capital.  Investors will continue to bet on a cyclical recovery but will also become more concerned about tax hikes on one hand and excessive deficit spending on the other. The latter threatens eventually to overheat the economy and speed up the Fed’s rate hike cycle. In this report we conduct a quick recap of the ARPA now that it is official law, we review the tax hike proposals swirling out of the Washington rumor mill, and we update the status of the civil war in the Republican Party. We conclude with a look at industrial stocks, which have rallied tremendously on the back of the cyclical economic upturn (Chart 1) but may still offer some value relative to sectors like health care that face policy risks. Chart 1Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus ARPA Symbolizes The ‘Big Government’ Shift The well-known provisions of the ARPA include: Treasury checks of $1,400 sent directly to individuals who earn less than $80,000 per year; extended unemployment benefits and a renewed federal top-up of $300 per week through September 6, 2021; $65 billion in business aid; and generous funding for various welfare programs such as the expanded Child Tax Credit and larger subsidies for enrollees in the Affordable Care Act health insurance marketplaces (Chart 2).1 Chart 2American Rescue Plan Act Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors In total the US fiscal stimulus amounts to $5 trillion or 23% of GDP since COVID-19 emerged, with $2.8 trillion or 13% of GDP passed since December. It is a gargantuan fiscal stimulus that will supercharge the economy today but lead to a rocky descent once it is exhausted in the coming years (Chart 3). Expiring provisions will occasion political showdowns over whether to make them permanent and how to address waste, corruption, and the long-term budget deficit. Chart 3The COVID-19 Fiscal Blowout Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The provisions are so far flung that educated American citizens living abroad are reportedly receiving stimulus checks. Nevertheless the bulk of the impact will be felt by low-income people with high marginal propensities to consume. They are the prime beneficiaries of the $850 billion share of the law that funnels cash to individuals as opposed to businesses (Chart 4). This means that at least one-third of the money will be spent, while around two-thirds will be used to pay down debt, enabling consumers to spend more later, according to our Global Investment Strategy. The general effects are very supportive of the recovery. For example, the number of children living in poverty is estimated to fall by 40%, while about one in five renters are expected to catch up on their rent.2 Evictions, bankruptcies, and loan delinquencies will not revive in this context. The total amount of spending is almost twice the size of the output gap, which is now widely expected to be filled by the end of 2022.  Chart 4Cash Handouts To Families With High Propensity To Consume Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors While ARPA mainly consists of short-term cash relief – with pro-productivity investments to come in the reconciliation bill for FY2022 focused on infrastructure and renewables – nevertheless it is not wholly devoid of long-term investment. Each of the 50 states will receive $500 million in aid (more depending on their unemployment rate). Since state and local government revenues are not as dire as expected, some of this money will go into infrastructure, including soft infrastructure like the rural broadband buildout. States will be discouraged from cutting taxes, as mentioned.3 The most important takeaway is that the ARPA will reinforce the shift in public attitudes in favor of a larger government role in the economy. Democrats passed their “liberal wish list” and the result is that a range of constituencies – from those on food and housing programs to those working in the health and education systems – will receive a windfall of federal support. In this way a one-off and probably excessive relief bill will contribute to a sea change in American attitudes toward government. Conservatives and Republicans will still argue in favor of limited government but that is a relative concept and the goalposts just moved. Bottom Line: The ARPA secures the recovery, plugs the output gap, and likely reinforces the shift in public attitudes in favor of a larger role of government in society and the economy. The amount of stimulus is likely excessive, assuming the economy avoids any other bad shocks in the coming years. Hence the law marks a historic shift from reactive to proactive fiscal policy and sets the stage for an inflation overshoot in the long run if not the short run.  Yellen Becomes Warren? Not Quite, But Expect Negative Tax Surprises The next budget reconciliation bill is expected to be a 10-year green infrastructure package that will be partially offset by tax hikes. Whether in the same bill, or prioritized above it, we expect Biden to push for his expansion of the Affordable Care Act (only a small part of his health agenda was included in the ARPA). The House will draft its version in April and Biden may sign the final bill into law as early as September or as late as December. We discussed the bill in our March 3 missive. Rumors about the tax proposals are starting to leak out of Washington. At present none of the rumors change the policy consensus, based on Biden’s campaign proposal shown in Table 1. However, they do tentatively support our view that tax hikes will deliver negative surprises to the equity market this year, given that investors have so far been unperturbed by the prospect of higher taxes. Table 1Taxman Cometh Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Secretary of Treasury Janet Yellen raised some eyebrows when she indicated that a wealth tax is being considered by the Biden administration.4 Previously a tax on a person’s (or trust’s) net assets, as opposed to a tax on their income, was the domain of Biden’s progressive-left rivals such as Senators Bernie Sanders and Elizabeth Warren. Warren’s proposal would levy a 2% annual tax on those who possess more than $50 million in net wealth, rising to 3% on billionaires. During the Democratic primary election their proposals were estimated to raise anywhere from $1.4 trillion – if Warren’s proposal met with extreme tax avoidance – to $4.5 trillion, as estimated by Sanders.5  Yellen has also spoken to the finance ministers of France and Germany as part of a diplomatic initiative through the OECD to encourage global participation in a minimum corporate tax rate of around 12%. In exchange for enacting this tax floor, Yellen signaled to the Europeans that she would not insist on providing American Big Tech with a “safe harbor” from Europe’s planned digital tax.6 Whatever ends up happening internationally, the implication is that the Biden administration will push forward with its proposed 15% minimum tax on corporation’s book income. Yellen says that she expects tax hikes to be phased in the latter part of the 10-year budget window for FY2022 so as to make sure that the government’s interest burden is manageable over the long run. She is not concerned about excess deficits or debt in the short run, as they are related to the pandemic relief and economic recovery and interest rates are below the nominal growth rate of the economy. But she has endorsed passing tax hikes for later in the decade, as did both President Biden and Vice President Kamala Harris on the campaign trail.  Several of the more ambitious tax proposals face limitations in Congress. Moderate senators like Joe Manchin of West Virginia have raised objections to a large tax hike during trying times. He might be joined by other moderates like John Tester of Montana and the four narrowly elected senators from Arizona and Georgia. However, while these moderates will keep the tax agenda in check, it is important to understand their position. None of these senators are against tax hikes in principle – that would be a Republican stance. They are against tax hikes that increase the burden on the middle class or jeopardize the economic recovery. From that point of view Biden’s proposals are fairly palatable: the highest individual income tax bracket would go back to where it stood in 2016, the corporate rate would go halfway (at most) to its pre-Trump level, and the estate tax would be restored. These proposals focus on big corporations and the wealthy and are likely to be watered down in negotiation, so we would not rule out moderate Democratic support.  Investors should not rest easy about the tax agenda until more information is known. Negative surprises are likely. The consensus is that the Democrats will not pass a wealth tax, or a “Wall Street tax” on financial transactions, or other progressive proposals. But these taxes would be popular and politically defensible – some polls even show a majority of Republicans supporting a wealth tax.  Therefore these taxes cannot be ruled out in advance.7 Bottom Line: The tax debate is underway and our expectation of negative surprises is looking more, not less, likely. How Will Republicans Respond To The Big Government Onslaught?   Republicans have duly retreated to the political wilderness after their election loss and the January 6 Capitol Hill riot. The critical question is whether and how they will regroup to contest future elections – the deeper their divisions, the more certain Democratic policy becomes. At the center of this question is whether the Republican Party will adopt Trumpist policy and whether Trump himself will continue to be the flagbearer and presumptive nominee for the presidential election in 2024. Our answer is that the Republicans will adopt a Trumpist agenda of tough trade and immigration policies combined with fiscal largesse but they will struggle over Trump himself and how to broaden their base. Every election is unique. COVID-19 reinforces the point. There is a clear case to be made that Trump would have won the election if not for the pandemic and recession. We favor this view given how narrowly he lost in the midst of the crisis. But there is also a clear case to be made that he would have lost anyway.8 The problem for the Republicans going forward is that cyclical and structural trends work against them. Cyclically, the economy should be in full stride in 2022-24 and the Federal Reserve is highly likely to play a supportive role. This may or may not prevent the usual midterm opposition gains but it will make it very hard for an opposition presidential candidate to win. True, Democrats will not have a full incumbent advantage if President Biden passes the baton to Vice President Harris. Inflation and other problems will emerge. But given the timing of the pandemic, election, and vaccine, voters will probably be much better off in four years than they were last November, which is the most reliable prediction of whether the incumbent party will stay in power.      Structurally, demographic change in America diminishes Trump’s base. A generational shift is transforming the American electorate, as the Silent Generation, which is the most reliably Republican, passes on (Chart 5). Millennials favored the Democratic Party by 6% in the 2020 election (10% in Georgia and 21% in Pennsylvania). Chart 5Generational Shift A Risk To Unreconstructed Republicans Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Ethnic minorities also skew Democratic, generally speaking, and are taking a much larger share of the electorate, especially in critical swing states – as highlighted by Biden’s victories in Arizona and Georgia (Chart 6). Hispanics favored Biden by 33% (24% in Arizona). Chart 6US Demographics Drive Political Change Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographic extrapolations by the Center for American Progress show that even if post-Millennial generations grow more conservative over time, the Electoral College will shift inexorably against the Republicans as long as current trends continue (Chart 7). Chart 7Electoral Math Frowns On Republicans Even Without Generational Shift Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographics are not destiny: Trump would never have won in 2016 if projections based on age and race were so predictive. Yet Republicans cannot merely wait on cyclical or exogenous events to discredit the Democrats. The electoral math is devastating if they do not broaden their appeal. Their quandary is that generating enthusiasm among their base of white voters with less formal education may exclude the very groups to whom they need to appeal: suburban women, educated whites, and ethnic minorities. The immediate question is what to do about Trump, who has divided the party over the Capitol riot, culminating in seven Republican votes against him in his second impeachment. On the surface the Republican Party is a much older entity than any single member or leader and can therefore play a longer strategy. It could choose the correct electoral strategy of courting independents, women, and Hispanics even if it meant losing an election or two due to divisions with the Trumpists. The problem is that Trump’s personal following is uniquely threatening to the viability of the party. Trump alone could split the Republican Party and nullify its chances in 2022-24 and beyond. Trump has suggested starting his own party, the Patriot Party. Opinion polls show that 46% of Republicans would join it while only 27%would insist on sticking with the Republican Party (Chart 8). Even if a Trumpist party stole only 2-3% of Republican voters it would be enough to ensure a Democratic victory in any election given the very small margins of victory in swing states in recent decades. Trump would easily spoil the Republican bid, just as Ross Perot did in the 1990s, Robert La Follette did for the Democrats in the 1930s, and Theodore Roosevelt did in 1912 (Table 2). As Senator Lindsey Graham said of Trump and the Republican Party, after holding post-election negotiations with the former president: “He can make it bigger. He can make it stronger. He can make it more diverse. And he also could destroy it.”9 Chart 8Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table 2Major Third Party Breakaway Candidates Undercut Their Former Party Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors So What Will Republicans Do? We conducted an exercise using game theory to determine the likeliest strategy that Trump and the party will take. We used the famous “Prisoner’s Dilemma” as our template because both sides have a lot to gain if they cooperate and a lot to lose if not.10 But they do not trust each other. And each side will lose the most if it stays true while the other betrays it, worsening the distrust. Diagram 1 shows the outcome. Republicans could win eight years in the Oval Office if they adopted Trump’s agenda yet put forward a young new candidate with Trump’s personal endorsement; or they could win four years if they chose Trump himself (the constitutional limitation). By contrast, if they chose an establishment Republican agenda, they could win eight years (reduced to four in Diagram 1 because less likely) or zero years if Trump opposed. Trump, for his part, would win zero years if he bowed out to support the Republicans regardless of whether they adopted his agenda, but he would have a chance of winning four more years if he ran at the head of a Trumpist Republican Party. The outcome is that the Republicans will adopt Trumpism while Trump himself could easily run for president again, given his sway over the party. Diagram 1Game Theory Says Republicans Will Court Trump Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The game works out the same way if we assign minimal positive payoffs (e.g. one point for a win, zero points for a loss), various other probability weighted payoffs (50% chance of winning), or negative payoffs for time spent out of power. In each variation a stable equilibrium emerges in which Republicans adopt Trump’s agenda and Trump runs again in 2024. Of course, if one changes the structure of the game or assigns subjective scores a different outcome can be produced. But the clearest and most logical games all produce the same outcome: Trump 2024.   This view fits with the consensus in online betting markets. According to the bookies, Trump has between a 20% and 35% chance of running as the Republican nominee in 2024. The same markets give Republicans a 44%-50% chance of winning the White House that year. At this early stage we would take the “over” on Trump and the “under” on a GOP victory given the above points about the cyclical and structural factors weighing against Republicans (Chart 9). Our quantitative US election model, which produced the correct result for all states except Arizona, Georgia and Michigan in 2020, gives the Republicans a 44% chance of winning in 2024 but that number will fall sharply as the economy improves. Chart 9Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 What might change this outcome, according to game theory? Republicans could offer a powerful sweetener to convince Trump to bow out of the race and support the party’s candidate, such as letting one of his children or his son-in-law Jared Kushner run in his place. Alternately Democrats could increase the danger to Trump of their winning again, perhaps by threatening to throw him in jail. Otherwise Trump may not be sufficiently convinced of his party’s loyalty, or frightened of Democratic rule, to bow out of the race.  We are never beholden to game theory and there are countless real-world ways in which the 2022-24 election outlook could change. But as things stand today, Republicans are highly likely to adopt Trump’s agenda. Trump may or may not do what is best for the party. He is unpredictable and at critical junctures over the past year he has not done so. He could start his own party just for the fun of it and in doing so break the party of Lincoln. This irrational factor creates an imbalance in the game that the Republican Party will be anxious to prevent, reinforcing its likely decision to adopt his agenda and let him seek the nomination freely. If the Republican Party does split, officially or unofficially, the Democrats will be guaranteed to expand their hold on Congress in 2022 and keep the White House in 2024. Note that Republicans would normally be heavily favored to retake the House of Representatives in 2022, though not the Senate, so such an outcome would be a political earthquake. A Democratic ascendancy could last for more than one election cycle: Republicans held the White House from 1980-92 and Democrats held it from 1932-52. Since we cannot reliably forecast Trump’s individual behavior, we cannot rule out a deep Republican rift. On the other hand, while the demographic trends point to Democratic rule out to 2036 and beyond, no Democratic ascendancy would last that long, given economic cycles, international threats, and the inevitable corruptions of single-party rule. But policy uncertainty would collapse over the 2022-24 cycle, pushing the timing of major policy change to 2026 or later. Investors would face a high probability that a sweeping Democratic agenda would be enacted, even assuming the persistence of checks and balances provided by moderate Democratic senators and the judicial branch. One clear implication is that financial markets may not evade the risk of negative regulatory and tax surprises over the long run even if they manage to do so in the FY2022 and FY2023 reconciliation bills – which we doubt. Bottom Line: Republicans cannot win the White House in 2024 without Trump’s popular base, even though they would prefer to have a fresh face capable of expanding that base. Trump cannot win without the Republican Party but he can unpredictably decide to do something other than win, i.e. endorse a Republican successor or start a third party. As a result a true Republican split cannot be ruled out. Meanwhile Republicans will have to court Trump rather than vice versa. Democratic policy is well ensconced for now, an underrated risk to the equity market. Investment Takeaways We know that Democrats are pushing forward on their legislative agenda and capable of passing one or two more budget reconciliation bills. We know that cyclical and especially structural factors will put Republicans at a disadvantage in the 2024 presidential race and possibly even the 2022 midterm. We also know that the Republican Party has a non-negligible risk of fracturing due to Trump’s personal following and unpredictability. These points suggest investors should not bet against the current policy setup. The macro backdrop favors cyclical sectors such as industrials, energy, materials, and financials. In our US Political Risk Matrix we have highlighted that the policy backdrop is especially beneficial to industrials (Appendix, Table A1). This is reinforced by ARPA and Biden’s forthcoming reconciliation bills on infrastructure and green projects, subsidies for domestic production, and simultaneous attempts to reduce trade tensions with US allies and partners – if not with China. Of course, industrials have rallied enthusiastically alongside a sharp rebound in core durable goods orders, a more gradual improvement in non-residential capital expenditures, and an environment in which capex intentions will respond to a general domestic and global upswing (Chart 10). A weak dollar, premised on a global recovery, excess liquidity, lower interest rates for longer, and large budget and trade deficits, also favors the industrial sector and reinforces the recovery in global trade and growth. Rising commodity prices are driven by supply constraints as much as global demand, as our Commodity & Energy Strategy has showed in depth, and help to restore pricing power to industrial firms  (Chart 11). Chart 10Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Chart 11Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Hence the good news is largely priced into industrials, which are tactically overvalued according to our BCA valuation indicator. The sector looks more or less expensive on all valuation metrics other than price-to-sales (Chart 12). Therefore the best value must be sought on a relative basis, where industrials are outperforming communications services and just beginning to outperform the superstars, tech and health care. From a policy point of view, health care is one of the biggest losers of the Biden administration, which aims to expand health insurance coverage and reduce drug prices. This may be for the benefit of society but it comes at the expense of old cash cows. Investors should stay guarded against a near-term correction in industrials due to looming tax hikes but strategically favor them over health care and tech (Chart 13), which are even more vulnerable to higher taxes. We will execute this trade by going long against health care over a strategic time frame. Chart 12Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Chart 13Favor Industrials Over Health Care Favor Industrials Over Health Care Favor Industrials Over Health Care Industrials also have a favorable profile against consumer discretionary stocks but we maintain a positive outlook on the US consumer in an era of government largesse. Our Geopolitical Strategy has also highlighted that Great Power struggle will prevent the Biden administration from cutting defense spending – another boon for industrials. Instead it will have to increase spending for defense as well as supply chain resilience and research and development in the midst of a cold war with China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1Political Risk Matrix Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A2Political Capital Index Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3APolitical Capital: White House And Congress Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3BPolitical Capital: Household And Business Sentiment Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3CPolitical Capital: The Economy And Markets Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A4Biden’s Cabinet Position Appointments Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors         Footnotes 1     Garrett Watson and Erica York, “The American Rescue Plan Act Greatly Expands Benefits Through The Tax Code In 2021,” Tax Foundation, March 12, 2021, taxfoundation.org.              2     Committee for a Responsible Federal Budget, “American Rescue Plan Act Will Help Millions And Bolster The Economy,” March 15, 2021, cbpp.org. 3    See footnote 2 above. 4    Paul Kiernan and Catherine Lucey, “Yellen Says Biden Administration Undecided On Wealth Tax,” Wall Street Journal, wsj.com. 5    Kyle Pomerleau, “How Much Revenue Would A Wealth Tax Raise?” On The Margin, American Enterprise Institute, April 20, 2020, aei.org. 6    Jeff Stein, “Yellen pushes global minimum tax as White House eyes new spending plan,” Washington Post, March 15, 2021, washingtonpost.com. 7     Howard Schneider and Chris Kahn, “Majority of Americans favor wealth tax on very rich: Reuters/Ipsos poll,” Reuters, January 10, 2020, reuters.com; Matthew Sheffield, “New poll finds overwhelming support for an annual wealth tax,” The Hill, February 6, 2019, thehill.com. 8    A recession could have happened as a result of the cyclical slowdown from the trade war, which hurt the Midwestern swing states. The yield curve had inverted and the economy’s margin of safety was low. There would not have been any fiscal stimulus without the pandemic. 9    James Walker, “Lindsey Graham Warns Donald Trump Could ‘Destroy’ GOP After Combative CPAC Speech,” Newsweek, March 8, 2021, newsweek.com. 10   The Prisoner’s Dilemma involves two prisoners detained separately and pressured into confessing their crimes. If they both stay quiet, nothing can be proved and they only spend one year in jail. If they both confess, they are proven guilty and both spend five years in jail. If only one of them confesses while the other stays silent, the confessor goes scot free while the other spends 20 years in jail! The incentive is to confess. The equilibrium is for both to confess. The traditional game reveals the benefits of trust as well as the difficulty of maintaining it in isolation and doubt.   

Highlights The Biden administration’s early actions suggest it will be hawkish on China as expected – and the giant Microsoft hack merely confirms the difficulty of reducing strategic tensions. US-China talks are set to resume and piecemeal engagement is possible. However, most of the areas of engagement touted in the media are overrated. Competition will prevail over cooperation. Cybersecurity stocks have corrected, creating an entry point for investors seeking exposure to a secular theme of Great Power conflict in the cyber realm and beyond. Global defense stocks are even more attractive than cyberstocks as a “back to work” trade in the geopolitical context. Continue to build up safe-haven hedges as geopolitical risk remains structurally elevated and underrated by financial markets. Feature The Biden administration passed its first major law, the $1.9 trillion American Rescue Plan, on March 10. This gargantuan infusion of fiscal stimulus accounts for about 2% of global GDP and 9% of US GDP, a tailwind for risky assets when taken with a receding pandemic and normalizing global economy. The US dollar has perked up so far this year on the back of this extraordinary pump-priming and the rapid rollout of COVID-19 vaccines, which have lifted relative growth expectations with the rest of the world. Hence the dollar is rising for fundamentally positive reasons that will benefit global growth rather than choke it off. Our Foreign Exchange Strategist Chester Ntonifor argues that the dollar has 2-3% of additional upside before relapsing under the weight of rising global growth, inflation expectations, commodity prices, and relative equity flows into international markets. We agree with the dollar bear market thesis. But there are two geopolitical risks that investors must monitor: Cyclically, China’s combined monetary and fiscal stimulus is peaking, growth will decelerate, and the central government runs a non-negligible risk of overtightening policy. However, China’s National People’s Congress so far confirms our view that Beijing will not overtighten. Structurally, the US-China cold war is continuing apace under President Biden, as expected. The two sides are engaging in normal diplomacy as appropriate to a new US administration but the Microsoft Exchange hack (see below) underscores the trend of confrontation over cooperation. Chart 1Long JPY / Short KRW As Geopolitical Risk Is Underrated Long JPY / Short KRW As Geopolitical Risk Is Underrated Long JPY / Short KRW As Geopolitical Risk Is Underrated The second point reinforces the first since persistent US pressure on China will discourage it from excessive deleveraging at home. In a world where China is struggling to cap excessive leverage, the US is pursuing “extreme competition” with China (Biden’s words), and yet the US rule of law is intact, global investors will not abandon the US dollar in a general panic and loss of confidence. They will, however, continue to diversify away from the dollar on a cyclical basis given that global growth will accelerate while US policy will remain extremely accommodative. Reinforcing the point, geopolitical frictions are rising even outside the US-China conflict. A temporary drop in risk occurred in the New Year as a result of the rollout of vaccines, the defeat of President Trump, and the resolution of Brexit. But going forward, geopolitical risk will reaccelerate, with various implications that we highlight in this report. While we would not call an early end to the dollar bounce, we will keep in place our tactical long JPY-USD and long CHF-USD hedges. These currencies offer a good hedge in the context of a dollar bear market and structurally high geopolitical risk. If the dollar weakens anew on good news for global growth then the yen and franc will benefit on a relative basis as they are cheap, whereas if geopolitical risk explodes they will benefit as safe havens. We also recommend going long the Japanese yen relative to the South Korean won given the disparity in valuations highlighted by our Emerging Markets team, and the fact that geopolitical tensions center on the US and China (Chart 1). “Our Most Serious Competitor, China” Why are we so sure that geopolitical risk will remain structurally elevated and deliver negative surprises to ebullient equity markets? Our Geopolitical Power Index shows that China’s rise and Russia’s resurgence are disruptive to the US-led global order (Chart 2). If anything this process has accelerated over the COVID-19 crisis. China and Russia have authoritarian control over their societies and are implementing mercantilist and autarkic economic policies. They are carving out spheres of influence in their regions and using asymmetric warfare against the US and its allies. They have also created a de facto alliance in their shared interest in undermining the unity of the West. The US is meanwhile attempting to build an alliance of democracies against them, heightening their insecurities about America’s power and unpredictability (Chart 3). Chart 2Great Power Struggle Continues Great Power Struggle Continues Great Power Struggle Continues Massive fiscal and monetary stimulus is positive for economic growth and corporate earnings but it reduces the barriers to geopolitical conflict. Nations can pursue foreign and trade policies in their self-interest with less concern about the blowback from rivals if they are fueled up with artificially stimulated domestic demand. Chart 3Biden: ‘Our Most Serious Competitor, China’ More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Total trade between the US and China, at 3.2% and 4.7% of GDP respectively in 2018, was not enough to prevent trade war from erupting. Today the cost of trade frictions is even lower. The US has passed 25.4% of GDP in fiscal stimulus so far since January 1, 2020. China’s total fiscal-and-credit impulse has risen by 8.4% of GDP over the same time period. The Biden administration is co-opting Trump’s hawkish foreign and trade policy toward China, judging by its initial statements and actions (Appendix Table 1). Specifically, Biden has issued an executive order on securing domestic supply chains that demonstrates his commitment to the Trumpian goal of diversifying away from China and on-shoring production, or at least offshoring to allied nations. The Democratic Party is also unveiling bipartisan legislation in Congress that attempts to reduce reliance on China.1 These executive decrees are partly spurred on by the global shortage of semiconductors. China, the US, and the US’s allies are all attempting to build alternative semiconductor supply chains that bypass Taiwan, a critical bottleneck in the production of the most advanced computer chips. The Taiwanese say they will coordinate with “like-minded economies” to alleviate shortages, by which they mean fellow democracies. But this exposes Taiwan to greater geopolitical risk insofar as it excludes mainland China from supplies, either due to rationing or American export controls. The surge in semiconductor sales and share prices of semi companies (especially materials and equipment makers) will continue as countries will need a constant supply of ever more advanced chips to feed into the new innovation and technology race, the renewable energy race, and the buildout of 5G networks and beyond (Chart 4). It takes huge investments of time and capital to build alternative fabrication plants and supply lines yet governments are only beginning to put their muscle into it via stimulus packages and industrial policy. Chart 4Semiconductor Supply Shortage Semiconductor Supply Shortage Semiconductor Supply Shortage Supply shocks have geopolitical consequences. The oil shocks of the 1970s and early 1990s motivated the US to escalate its interventions and involvement in the Middle East. They also motivated the US to invest in stockpiles of critical goods and alternative sources of production so as to reduce dependency (Chart 5). Although semiconductors are not fungible like commodities, and the US has tremendous advantages in semiconductor design and production, nevertheless the bottleneck in Taiwan will take years to alleviate. Hence the US will become more active in supply security at home and more active in alliance-building in Asia Pacific to deter China from taking Taiwan by force or denying regional access to the US and its allies. China faces the same bottleneck, which threatens its technological advance, economic productivity, and ultimately its political stability and international defense. Chart 5ASupply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Chart 5BSupply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Semiconductor and semi equipment stock prices have gone vertical as highlighted above but one way to envision the surge in global growth and capex for chip makers is to compare these stocks relative to the shares of Big Tech companies in the communication service sector, i.e. those involved in social networking and entertainment, such as Twitter, Facebook, and Netflix. On a relative basis the semi stocks can outperform these interactive media firms which face a combination of negative shocks from rising interest rates, regulation, economic normalization, and ideologically fueled competition (Chart 6). Chart 6Long Chips Versus Big Tech Long Chips Versus Big Tech Long Chips Versus Big Tech What about the potential for the US and China to enhance cooperation in areas of shared interest? Generally the opportunity for re-engagement is overrated. The Biden administration says there will be engagement where possible. The first high-level talks will occur in Alaska on March 18-19 between Secretary of State Antony Blinken, National Security Adviser Jake Sullivan, Central Foreign Affairs Commissioner Yang Jiechi, and Foreign Minister Wang Yi. Presidents Biden and Xi Jinping may hold a bilateral summit sometime soon and the old strategic and economic dialogue may resume, enabling cabinet-level officials to explore a range of areas for cooperation independently of high-stakes strategic negotiations. However, a close look at the policy areas targeted for engagement reveals important limitations: Health: There is little room for concrete cooperation on the COVID-19 pandemic given that the pandemic is already receding, the Chinese have not satisfied American demands for data transparency, Chinese officials have fanned theories that the virus originated in the US, and the US is taking measures to move pharmaceutical and health equipment supply chains out of China. Trade: Trade is an area of potential cooperation given that the two countries will continue trading while their economies rebound. The Phase One trade deal remains in place. However, China only made structural concessions on agriculture in this deal so any additional structural changes will have to be the subject of extensive negotiations. Secretary of Treasury Janet Yellen says the US will use the “full array of tools” to ensure compliance and will punish China for abuses of the global trade system. Cybersecurity: On cybersecurity, China greeted the Biden administration by hacking the Microsoft Exchange email system, an even larger event than Russia’s SolarWinds hack last year. Both hacks highlight how cyberspace is a major arena of modern Great Power struggle, making it unlikely that there will be effective cooperation. The hack suggests Beijing remains more concerned about accessing technology while it can than reducing tensions. The Americans will make demands of China at the Alaska meetings. Environment: As for the environment, the US is a net oil exporter while China imports 73% of its oil, 42% of its natural gas and 7.8% of its coal consumption, with 40% and 10% of its oil and gas coming from the Middle East. The US wants to be at the cutting edge of renewable energy technology but it has nowhere near the impetus of China (or Europe), which are diversifying away from fossil fuels for the sake of national security. Moreover China will want its own companies, not American, to meet its renewable needs. This is true even if there is success in reducing barriers for green trade, since the whole point of diversifying from Middle Eastern oil supplies is strategic self-sufficiency. The Americans would have to accept less energy self-sufficiency and greater renewable dependence on China. Nuclear Proliferation: Cooperation can occur here as the Biden administration will seek to return to a deal with the Iranians restraining their nuclear ambitions while maintaining a diplomatic limiting North Korea’s nuclear weapons stockpile and ballistic missile development. China and Russia will accept the US rejoining the 2015 Iranian nuclear deal but they will require significant concessions if they are to join the US in forcing anything more substantial on the Iranians. China may enforce sanctions on North Korea but then it will expect concessions on trade and technology that the Biden administration will not want to give merely for the sake of North Korea. Bottom Line: The Biden administration’s China strategy is taking shape and it is hawkish as expected. It is not ultra-hawkish, however, as the key characteristic is that it is a defensive posture in the wake of the perceived failures of Trump’s strategy of “attack, attack, attack.” This means largely maintaining the leverage that Trump built for the US while shifting the focus to actions that the US can take to improve its domestic production, supply chain resilience, and coordination with allied producers. Punitive measures are an option, however, and if relations deteriorate over time, as expected, they will be increasingly relied on. Buy The Dip In Cybersecurity Stocks A linchpin of the above analysis is the Microsoft Exchange hack, which some have called the largest hack in US history, since it confirms the view that the Biden administration will not be able to de-escalate strategic tensions with China much. China has been particularly frantic to acquire technology through hacking and cyber-espionage over the past decade as it attempts to achieve a Great Leap Forward in productivity in light of slowing potential growth that threatens single-party rule over the long run. The breakdown in ties between Presidents Barack Obama and Xi Jinping occurred not only because of Xi’s perceived violation of a personal pledge not to militarize the South China Sea but also because of the failure of a cybersecurity cooperation deal between the two. When the Trump administration arrived on the scene it sought to increase pressure on China and cybersecurity was immediately identified as an area where pushback was long overdue. Cyber conflict is highly likely to persist, not only with Russia but also with China. Cyber operations are a way for states to engage in Great Power struggle while still managing the level of tensions and avoiding a military conflict in the real world. The cyber realm is a realm of anarchy in which states are insecure about their capabilities and are constantly testing opponents’ defenses and their own offensive capabilities. They can also act to undermine each other with plausible deniability in the cyber realm, since multiple state and quasi-state actors and a vast criminal underworld make it difficult to identify culprits with confidence. Revisionist states like China, North Korea, Russia, and Iran have an advantage in asymmetric warfare, including cyber, since it enables them to undermine the US and West without putting their weaker conventional forces in jeopardy. Cybersecurity stocks have corrected but the general up-trend is well established and fully justified (Chart 7). It is not clear, however, that investors should favor cybersecurity stocks over the general NASDAQ index (Chart 8). The trend has been sideways in recent years and is trying to form a bottom. Cybersecurity stocks are volatile, as can be seen compared to tech stocks as a whole, and in both cases the general trend is for rising volatility as the macro backdrop shifts in favor of higher interest rates and inflation expectations (Chart 9). Chart 7Cyber Security Stocks Corrected Cyber Security Stocks Corrected Cyber Security Stocks Corrected Chart 8Major Hacks Failed To Boost Cyber Vs NASDAQ Major Hacks Failed To Boost Cyber Vs NASDAQ Major Hacks Failed To Boost Cyber Vs NASDAQ Chart 9Volatility Of Cyber & Tech Stocks Rising Volatility Of Cyber & Tech Stocks Rising Volatility Of Cyber & Tech Stocks Rising Great Power struggle will not remain limited to the cyber realm. There is a fundamental problem of military insecurity plaguing the world’s major powers. Furthermore the global economic upturn and new energy and industrial innovation race will drive up commodity prices, which will in turn reactivate territorial and maritime disputes. Turf battles will re-escalate in the South and East China Seas, the Persian Gulf and Indian Ocean basin, the Mediterranean, and even the Baltic Sea and Arctic. One way to play this shift is as a geopolitical “back to work” trade – long defense stocks relative to cybersecurity stocks (Chart 10). The global defense sector saw a run-up in demand, capital expenditures, and profits late in the last business cycle. That all came crashing down with the pandemic, which supercharged cybersecurity as a necessary corollary to the swarm of online activity as households hunkered down to avoid the virus and obey government social restrictions. Cybersecurity stocks have higher EV/EBITDA ratios and lower profit margins and return on equity compared to defense stocks or the broad market. Chart 10Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics The trade does not mean cybersecurity stocks will fall in absolute terms – we maintain our bullish case for cybersecurity stocks – but merely that defense stocks will make relative gains as economic normalization continues in the context of Great Power struggle. Bottom Line: Structurally elevated geopolitical risks will continue to drive demand for cybersecurity in absolute terms. However, we would favor global defense stocks on a relative basis. The US Is Not As War-Weary As People Think America is consumed with domestic divisions and distractions. Since 2008 Washington has repeatedly demonstrated an unwillingness to confront foreign rivals over small territorial conquests. This risk aversion has created power vacuums, inviting ambitious regional powers like China, Russia, Iran, and Turkey to act assertively in their immediate neighborhoods. However, the US is not embracing isolationism. Public opinion polling shows Americans are still committed to an active role in global affairs (Chart 11). The 2020 election confirms that verdict. Nor are Americans demanding big cuts in defense spending. Only 31% of Americans think defense spending is “too much” and only 12% think the national defense is stronger than it needs to be (Chart 12). Chart 11No Isolationism Here No Isolationism Here No Isolationism Here True, the Democratic Party is much more inclined to cut defense spending than the Republicans. About 43% of Democrats demand cuts, while 32% are complacent about the current level of spending (compared to 8% and 44% for Republicans). But it is primarily the progressive wing of the party that seeks outright cuts and the progressives are not the ones who took power. Chart 12Americans Against ‘Forever Wars’ But Not Truly Dovish More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Biden and his cabinet represent the Washington establishment, including the military-industrial complex. Even if Vice President Kamala Harris should become president she would, if anything, need to prove her hawkish credentials. Defense spending cuts might be projected nominally in Biden’s presidential budgets but they will not muster majorities in the two narrowly divided chambers of Congress. Biden has co-opted Trump’s (and Obama’s) message of strategic withdrawal and military drawdown. He is targeting a date of withdrawal from Afghanistan on May 1, notwithstanding the leverage that a military presence there could yield in its priority negotiations with Iran. Yet he is not jeopardizing the American troop presence in Germany and South Korea, much more geopolitically consequential spheres of action in a long competition with Russia and China. While it is true (and widely known) that Americans have turned against “forever wars,” this really means Middle Eastern quagmires like Iraq and Afghanistan and does not mean that the American public or political establishment have truly become anti-war “doves.” The US public recognizes the need to counter China and Russia and Congress will continue appropriating funds for defense as well as for industrial policy. The Biden administration will increase awareness about the risks of a lack of deterrence and alliance-building. This is especially apparent given the military buildup in China. The annual legislative session has revealed an important increase in military focus in Beijing in the context of the US rivalry. Previously, in the thirteenth five-year plan and the nineteenth National Party Congress, the People’s Liberation Army aimed to achieve “informatization and mechanization” reforms by 2020 and total modernization by 2035. However, at the fifth plenum of the central committee in October, the central government introduced a new military goal for the PLA’s 100th anniversary in 2027 – a “military centennial goal” to match with the 2021 centennial of the Communist Party and the 2049 centennial goal of the founding of the People’s Republic. While details about this new military centenary are lacking, the obvious implication is that the Communist Party and PLA are continuing to shift the focus to “fighting and winning wars,” particularly in the context of the need to deter the United States. The official defense budget is supposed to grow 6.8% in 2021, only slightly higher than the 6.6% goal in 2020, but observers have long known that China’s military budget could be as much as twice as high as official statistics indicate. The point is that defense spending is going up, as one would expect, in the context of persistent US-China tensions. Bottom Line: Just as US-China cooperation will be hindered by mutual efforts to reduce supply chain dependency and support domestic demand, so too it will be hindered by mutual efforts to increase defense readiness and capability in the event of military conflict. The beneficiary of continued high levels of US defense spending and Chinese spending increases – in the context of a more general global arms buildup – will be global arms makers. Investment Takeaways Geopolitical risk remains structurally elevated despite the temporary drop in tensions in late 2020 and early 2021. The China-backed Microsoft Exchange hack reinforces the Biden administration’s initial foreign policy comments and actions suggesting that US policy will remain hawkish on China. While Biden will adopt a more defensive rather than offensive strategy relative to Trump, there is no chance that he will return to the status quo ante. The Obama administration itself grew more hawkish on China in 2015-16 in the face of cyber threats and strategic tensions in the South China Sea. Cybersecurity stocks will continue to benefit from secular demand in an era of Great Power competition where nations use cyberattacks as a form of asymmetric warfare and a means of minimizing the risks of conflict. The recent correction in cybersecurity stocks creates a good entry point. We closed our earlier trade in January for a gain of 31% but have remained thematically bullish and recommend going long in absolute terms. We would favor defense over cybersecurity stocks as a geopolitical version of the “back to work” trade in which conventional economic activity revives, including geopolitical competition for territory, resources, and strategic security. Defense stocks are undervalued and relative share prices are unlikely to fall to 2010-era lows given the structural increase in geopolitical risk (Chart 13). Chart 13Global Defense Stocks Oversold Global Defense Stocks Oversold Global Defense Stocks Oversold Chart 14Global Defense Stocks Profitable, Less Indebted Global Defense Stocks Profitable, Less Indebted Global Defense Stocks Profitable, Less Indebted Defense stocks have seen profit margins hold up and are not too heavily burdened by debt relative to the broad market (Chart 14). Defense stocks have a higher return on equity than the average for non-financial corporations and cash flow will improve as a new capex cycle begins in which nations seek to improve their security and gain access to territory and resources (Chart 15). Chart 15Defense Stocks: High RoE, Capex Will Revive Defense Stocks: High RoE, Capex Will Revive Defense Stocks: High RoE, Capex Will Revive Chart 16Discount On Global Defense Stocks Discount On Global Defense Stocks Discount On Global Defense Stocks Valuation metrics show that global defense stocks are trading at a discount (Chart 16).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table 1 Appendix Table 1Biden Administration's First 100 Days: Key Statements And Actions On China More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Footnotes 1 See Federal Register, "America’s Supply Chains", Mar. 1, 2021, federalregister.gov and Richard Cowan and Alexandra Alper, "Top U.S. Senate Democrat directs lawmakers to craft bill to counter China", Feb. 23, 2021, reuters.com.

Highlights The miserable performance of commodities as an asset class post-GFC (since 2010) has disincentivized investment in oil and metals, which means growth in supply will lag demand going forward (Chart of the Week). Energy: Bullish. OPEC 2.0’s massive spare capacity supports its production-management strategy, and will keep crude-oil forward curves in backwardation. Base Metals: Bullish. With supply growth flat to negative year-on-year (y/y), copper and aluminium will post physical deficits as demand ex-China recovers. This will keep their forward curves backwardated as well. Precious Metals: Bullish. We expect the Fed’s ultra-accommodative policy to keep US real rates low, and return the USD to a bear market. This will be bullish for gold. Ags/Softs: Neutral. Ag markets remain balanced, punctuated by periodic weather-related rallies. A weaker USD also will be bullish for grains. In line with our expectation for stronger prices, continued backwardation in industrial commodities and a weaker USD, we are getting long the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT) at tonight’s close. This will broaden our exposure to commodities as an asset class. Risks due to COVID-19 persistence and a higher USD demand remain. The balance of risk, however, is to the upside. Feature Commodities as an asset class performed miserably post-Global Financial Crisis (GFC), as the Chart of the Week demonstrates. Partly this is due to the erratic-but-ultimately-accommodative monetary policies globally coming out of the GFC, which went into hyperdrive during the COVID-19 pandemic and supercharged demand for financial assets. During this period, industrial commodities suffered from periodic surpluses resulting from overproduction set off by high prices at the beginning of the 2000s when China set off a global commodity super-cycle. In the post-GFC world, producers brought commodities to market almost oblivious to the state of demand. This over-investment on the supply side led to market-share wars in oil and bulks like iron ore, which were ruinous to producers. Endogenous factors were not the only source of under-performance for commodities post-GFC. Stop-and-go fiscal stimulus in EM markets, which made base metals demand difficult to forecast; massive crop harvests and carry-over stocks year after year; highly erratic trade policy that distorted the flow of ags and manufactured products with out-of-the-blue tariffs, and a once-in-a-century pandemic that wiped out ~ 10% of global oil demand, all contributed to weak and volatile market conditions. Chart of the WeekCommodities As An Asset Class Performed Miserably Post-GFC The Case For A Strategic Allocation To Commodities As An Asset Class The Case For A Strategic Allocation To Commodities As An Asset Class Commodity producers, too, incentivized investors to seek greener pastures over this period, owing to their inability to earn returns in excess of their cost of capital, let alone anything even close to the returns available in the tech-heavy growth sector of equities markets. Producers’ difficulties have been compounded by the growing importance of ESG investing (Environmental, Social, and Governance), which, over time will increase the cost of producing commodities compliant with consumers’ and investors’ stated preferences for sustainable and equitable business practices. Investors, as is their wont, made it perfectly clear they have no interest investing in firms that cannot produce commodities profitably in line with ESG goals. There are too many opportunities elsewhere to invest in firms that can deliver goods and services profitably, regardless of how important commodities might be to the global economy. Industrial commodity markets, particularly oil and metals, now are under-resourced on the supply side, just as demand ex-China recovers in the wake of massive fiscal and monetary stimulus – with more on the way in the US. The Return Of Commodity-Index Investing For investors in long-only commodity-index instruments that provided a source of uncorrelated returns at the turn of the 21st century, the post-GFC period was long and painful. However, the balance of risks in these instruments – given the underlying fundamentals in the largest sectors of the asset class – is decidedly to the upside. Returns from long-only commodity indexes are derived from price appreciation of the index, so-called roll-yields, and the return on collateral used to post margin to support futures and exchange-cleared swaps comprising the index.1 In the industrial commodities, price gains have come from tightening markets – i.e., demand levels exceed supply levels, pushing prices higher. In oil, OPEC 2.0’s production-management strategy has been remarkably successful in reducing the supply overhang that has plagued markets on and off for the entire post-GFC period (Chart 2). Chart 2Oil Demand Will Exceed Supply Per OPEC 2.0 Strategy Oil Demand Will Exceed Supply Per OPEC 2.0 Strategy Oil Demand Will Exceed Supply Per OPEC 2.0 Strategy On the metals side, production growth has flattened in copper (Chart 3) and aluminum (Chart 4) as demand ex-China starts to recover. We expect physical deficits this year and next. Chart 3Copper's Physical Deficits Will Keep Futures Bacwardated Copper's Physical Deficits Will Keep Futures Bacwardated Copper's Physical Deficits Will Keep Futures Bacwardated Chart 4Flat To Backwardated Aluminum Forwards Expected Flat To Backwardated Aluminum Forwards Expected Flat To Backwardated Aluminum Forwards Expected In the case of copper, this will extend a two-year stretch of zero supply growth that has forced inventories to draw globally. Prices have rallied sharply on the back of these deficits, but will have to be sustained at these levels – and go higher – to spark investment in new supply necessary to support a revival of global economic growth; the buildout of renewable generation and new grids, and consumer-driven electric vehicles (EVs) demand. The only market that we are not bullish on due to tightening fundamentals is ags. While global grain and soybean inventories are falling (Chart 5), it’s a mixed picture. Global bean stocks are down (Chart 6), as are corn stocks (Chart 7). Wheat stocks are moving higher (Chart 8), while rice stocks remain roughly flat y/y (Chart 9). Chart 5Global Grain Balances Tightening Slightly Global Grain Balances Tightening Slightly Global Grain Balances Tightening Slightly Chart 6Global Bean Stocks Are Falling... Global Bean Stocks Are Falling... Global Bean Stocks Are Falling... Chart 7...As Are Corn's Fundamentals ...As Are Corn's Fundamentals ...As Are Corn's Fundamentals Chart 8Global Wheat Stocks Are Rising... Global Wheat Stocks Are Rising... Global Wheat Stocks Are Rising... Chart 9...While Rice Stocks Remain Balances ...While Rice Stocks Remain Balances ...While Rice Stocks Remain Balances Roll Yields From Industrial Commodities In addition to supply-demand fundamentals being supportive of industrial commodities’ price levels, we continue to expect a weakening of the USD, which will provide a strong tailwind to commodity price levels particularly gold, which we model primarily as a function of financial variables including the dollar and US real rates (Chart 10). A weaker USD also will be supportive of oil price levels, which have been in a long-term equilibrium with the dollar since 2000, when oil became a random-walking commodity (Chart 11).2 Metals also will get a lift from a weaker USD (Chart 12), as will ags (Chart 13), which remain balanced and well-supplied. This overall support to demand from the weaker dollar will, all else equal, put pressure on inventories and force them lower. Chart 10Weaker USD Will Boost Gold... Weaker USD Will Boost Gold... Weaker USD Will Boost Gold... Chart 11...Provide Oil A Tailwind... ...Provide Oil A Tailwind... ...Provide Oil A Tailwind... Chart 12...Lift Metals... ...Lift Metals... ...Lift Metals... Chart 13...And Ags ...And Ags ...And Ags This is particularly important for commodity-index investing, since falling inventories lead to backwardated forward curves, which are the principal source of roll yields in long-only index products.3 For long-only commodity index investors, the periods when commodities outperformed equities were characterized by backwardated forward curves, and, typically but not always, rising prices. Of the two factors driving commodity returns, backwardation is the most persistent and long-lived. Price increases (and decreases) often result from shocks. The market responds to a shock, finds a new level, and then oscillates randomly around it. Investment Implications We believe we are entering a period that will be characterized by tighter supply-demand balances for industrial commodities. The result of this will be lower inventories for oil and base metals, which will keep price levels well bid and forward curves flat to backwardated. A weaker USD will support industrial commodities, gold and ag prices. These are ideal conditions for long-only commodity-index investors. While there are numerous vehicles available to investors to express this view, we believe a dynamic portfolio approach – which chooses exposure for individual index components based on their backwardation – is best suited to current market conditions, given that we expect these markets to be in asynchronous bull markets over the next couple of years.4 At the close of business tonight, we will be getting long the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), in order to broaden our exposure to commodities as an asset class. This index is maintained by S&P Dow Jones Indices.5 Separately, in a housekeeping note, we were stopped out of our tactical nickel position with a loss of 15.8%, following a sudden sell-off Friday. Based on reporting from forbes.com, China’s Tsingshan Holding Group took the market by surprise with its news release that it is producing “a battery-grade form of nickel from low-grade saprolite ore, a technical breakthrough which threatens to flood the nickel market.”6 We will continue to evaluate this development vis-à-vis re-entering our tactical nickel position in the near term.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Roll yield refers to the gain from a commodity spread trade. A useful way to understand this is to imagine a market in which the forward curve is flat, i.e., the prompt futures contract for delivery next month is trading at the same price as a deferred futures contract specifying delivery in the following month. Assume an investor buys the prompt contract and the holds this position until it has to be either liquidated or rolled forward and its price has gone up, while the deferred contract’s price is unchanged. The investor can sell the prompt contract and use those proceeds to buy the deferred contract, which is still trading unchanged. The investor can either buy more of the contract with the proceeds from this trade, or invest it elsewhere. The gain from this transaction is referred to as the “roll yield.” In a backwardated market – this process can be repeated (buying at a low price and selling at a higher price as the futures contract rolls up the curve and gets closer to delivery), which is an ongoing source of yield. Of course prompt prices can fall below where the deferred contract was purchased, resulting in a loss, but typically the roll yield in a backwardated market is persistent. The opposite holds for contango market, which results in negative returns for investors buying, holding, and rolling futures seeking to earn roll yields. These spread trades are the commodity markets’ analog to the curve-steepeners and curve-flatteners in fixed income markets (e.g., the 2s-10s spread in U.S. Treasuries). 2     Please see Helyette Geman, (2007), "Mean Reversion versus Random Walk in Oil and Natural Gas Prices,“ in Advances in Mathematical Finance, Birkhäuser, Boston. 3    Please see Commodities As An Asset Class V. 3.0, a Special Report we published 21 August 2014. It is available at ces.bcaresearch.com. 4    We develop this thesis in last week’s Special Report entitled Industrial Commodities Super-Cycle Or Bull Market?, which is available at ces.bcaresearch.com. 5    Please see S&P GSCI Dynamic Roll, particularly its Methodology, which was published by S&P Global in January 2021. 6    Please see Nickel Price Falls By 16% But That Might Not Help EV Makers published by forbec.com 8 March 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Please note that we will be presenting a webcast on Thursday March 11 at 10:00 AM EST for the Americas and EMEA regions and on March 12 at 9:00 HKT/12:00 AEDT for APAC clients. We will be discussing macro themes and investment strategies. Highlights EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were in 2013. Yet better does not mean they will be unscathed. The combination of rising US bond yields and a firming US currency will suffocate EM risk assets in the near-term. A neutral allocation is warranted in EM stocks and credit markets within global equity and credit portfolios, respectively. Feature Ever since the US elections concluded in January with a Blue Sweep, we have been warning that rising US bond yields could trigger a setback in global markets in general, and in EM markets in particular. EM equities, currencies and fixed-income markets have recently experienced a correction (Chart 1). The question now is: Is the market rout over? Or is there more to come? We are inclined to believe that the correction is not over. Rising US Treasury yields have been the culprit of the shakeout in global growth stocks, EM equities, as well as EM currencies. Therefore, taking a stance on US bond yields and on the US dollar is critical for assessing the outlook for EM financial markets. Odds are that the selloff in US long-term bonds and the rebound in the US dollar are not yet over because: Positioning and sentiment on US long-dated Treasuries is neutral, as illustrated in Chart 2. Chart 1Rising US Real Yields Have Caused A Shakeout In EM Rising US Real Yields Have Caused A Shakeout In EM Rising US Real Yields Have Caused A Shakeout In EM Chart 2Investor Sentiment And Positioning In US Treasurys Are Neutral Investor Sentiment And Positioning In US Treasurys Are Neutral Investor Sentiment And Positioning In US Treasurys Are Neutral   Typically, US bond yields do not reverse their ascent until investor sentiment becomes downbeat and bond portfolios are of materially short duration. These conditions for a top in bond yields are not yet present. US government bond yields would have been much higher if it were not for the Federal Reserve and US commercial banks’ massive bond-buying spree. The Fed has bought $2.8 trillion and US commercial banks have purchased about $300 billion of Treasurys in the past 12 months (Chart 3). One of the main motives for commercial banks to buy US Treasurys has been the SLR relief initiative which commenced on April 1, 2020.1 This SLR relief is due to terminate on March 31, 2021. Unless it is extended, commercial banks will drastically curtail their net government bond purchases. This will exert upward pressure on Treasury yields. Regarding the greenback, investor sentiment remains quite bearish (Chart 4). From a contrarian perspective, this heralds further strength in the US dollar. Chart 3Surging Purchases Of US Treasurys By The Fed And Commercial Banks Surging Purchases Of US Treasurys By The Fed And Commercial Banks Surging Purchases Of US Treasurys By The Fed And Commercial Banks Chart 4Investors Are Still Bearish On The US Dollar Investors Are Still Bearish On The US Dollar Investors Are Still Bearish On The US Dollar   From a cyclical perspective, US growth will be stronger relative to its potential, and vis-à-vis other DMs, EMs and China. Growth differentials moving in favor of the US foreshadows near-term strengthening of the dollar. Structurally, the bearish case for the US currency hinges on both the Federal Reserve falling behind the inflation curve and ballooning US twin deficits. In our view, this will ultimately be the case. Hence, the long-term outlook for the US dollar remains troublesome. That said, twin deficits alone are insufficient to produce a continuous currency depreciation. The twin deficits must also be accompanied with low/falling real interest rates – in order to generate sufficient conditions for currency depreciation. As long as US real rates continue rising, the dollar’s rebound will be extended. The USD/EUR exchange rate has been correlated with the 10-year real yield differential and this relationship will persist (Chart 5).  Bottom Line: US government bonds will continue selling off. Rising bond yields (including rising real yields) will support the dollar in the near-term. The combination of rising US bond yields and a firming US currency will cause global macro volatility to rise (Chart 6). This will suffocate EM risk assets and EM currencies. Chart 5US Real Yields (TIPS) Will Continue Driving The US Dollar US Real Yields (TIPS) Will Continue Driving The US Dollar US Real Yields (TIPS) Will Continue Driving The US Dollar Chart 6Aggregate Financial Market Volatility: Higher Lows Aggregate Financial Market Volatility: Higher Lows Aggregate Financial Market Volatility: Higher Lows   Impact On EM: 2013 Versus Now Are we entering another Taper Tantrum episode as in the spring of 2013 when many EMs were devastated? There are both similarities and differences between the current period of rising US bond yields and the 2013 episode. Similarities: Today, as in early 2013, investor sentiment on EM is very bullish and investors are long EM (Chart 7). Chart 7Investor Sentiment On EM Stocks Was At A Record High In January Investor Sentiment On EM Stocks Was At A Record High In January Investor Sentiment On EM Stocks Was At A Record High In January In early 2013, as is the case today, EM local currency bond yields were very low and EM credit spreads were too tight. When US Treasury yields spiked in the spring of 2013, EM assets tanked. Many commentators blamed it on the Fed. We disagree with that interpretation. Remarkably, the rise in US TIPS yields in 2013 had little impact on equity indices such as the S&P 500 and Nasdaq, or on US corporate spreads (Chart 8). The correction in the US equity market lasted about a week. Yet, EM equities, fixed income markets and currencies experienced a prolonged slump, and in many cases, a bear market. There is no basis to believe that the Fed’s policy and US bond yields are more important to EM than they are to US credit and equity markets. The core rationale for the EM bear market in 2013 was poor domestic fundamentals. The Fed’s tapering was the trigger, not the cause. Differences: The key difference between the current episode and the 2013 Taper Tantrum is EM macro fundamentals. Specifically: EM economies (ex-China, Korea and Taiwan) entered 2013 with booming bank loans and strong domestic demand as well as high inflation (Chart 9). Chart 8US Markets Were Not Hit By The Taper Tantrum In 2013 US Markets Were Not Hit By The Taper Tantrum In 2013 US Markets Were Not Hit By The Taper Tantrum In 2013 Chart 9EM (ex-China, Korea And Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now Chart 10EM (ex-China, Korea And Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now EM (ex-China, Korea and Taiwan): 2013 Vs Now Presently, EM bank credit is subdued, domestic demand is dismal, and inflation is tame. Besides, EMs (ex-China, Korea and Taiwan) had a very large trade deficits in 2013 and were financing them via foreign borrowing, which was roaring prior to 2013 (Chart 10). Presently, their trade balances are in surplus and foreign indebtedness has not increased in recent years. Bottom Line: In 2013, EM economies (ex-China, Korea and Taiwan) were overheating and were addicted to foreign funding. These were the reasons why EM currencies and fixed income markets teetered when US bond yields spiked in 2013. Presently, the majority of EM economies (ex-China, Korea and Taiwan) have different types of malaises: domestic bank loan origination is too timid, consumer spending and capital expenditures are moribund, inflation is low and fiscal policy is tight. Consequently, EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were back in 2013. Yet better does not mean they will be unscathed. Investment Strategy Equities: The key variable to watch to assess the vulnerability of both US and EM equity markets is their respective corporate bond yields. Historically, rising corporate bond yields (shown inverted in both panels of Chart 11) heralds lower share prices. Chart 11Rising Corporate Bond Yields Are Bad For Share Prices Rising Corporate Bond Yields Are Bad For Share Prices Rising Corporate Bond Yields Are Bad For Share Prices Given that both EM and US corporate credit spreads are too tight, they are unlikely to narrow further to offset rising US Treasury yields. Instead, EM and US corporate bond yields are likely to rise with US Treasury yields. This will trigger more weakness in share prices. Besides, rising EM local currency government bond yields also point towards more downside in EM equities (yields are shown inverted on the chart) (Chart 12). Chart 12Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Concerning equity style, global growth stocks have peaked versus global value stocks. In the EM equity space, we have less conviction on growth versus value. As to regional allocation in a global equity portfolio, we continue recommending a neutral allocation to EM, underweighting US and overweighting Europe and Japan. Commodities: Investors’ net long positions in commodities are very elevated (Chart 13). As US bond yields rise and the US dollar continues rebounding, there will be a de-risking in the commodities space resulting in a pullback in commodities prices. Currencies: We continue shorting a basket of EM currencies – including BRL, CLP, ZAR, TRY and KRW versus the euro, CHF and JPY. Several EM currencies have failed to break above their technical resistance levels, suggesting that a pullback could be non-trivial (Chart 14). Chart 13Investors Are Record Long Commodities Investors Are Record Long Commodities Investors Are Record Long Commodities Chart 14Asian Currencies Hit Technical Resistances Asian Currencies Hit Technical Resistances Asian Currencies Hit Technical Resistances   In central Europe, we are closing the long CZK/short USD trade with a 3.8% gain. Continue holding the long CZK/short PLN and HUF position. Local fixed income markets: EM local bond yields have risen in response to rising US treasury real yields and the setback in EM currencies. This might persist in the near-term, but we continue to recommend receiving 10-year swap rates in selected countries where inflation risks are low and monetary and fiscal policies are tight. These countries include Mexico, Colombia, Russia, China, India and Malaysia. A further rise in their swap rates would represent an overshoot and hence, should not be chased. EM currencies are more vulnerable to a selloff than local rates are. We continue to wait for a better entry point in currencies to recommend buying cash domestic bonds instead of receiving swap rates. EM Credit: A neutral allocation to EM sovereign and corporate bonds is warranted in a global credit portfolio. Our sovereign credit overweights are Mexico, Russia, Malaysia, Peru, Colombia, the Philippines and Indonesia, while our sovereign credit underweights are Brazil, South Africa and Turkey. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The Supplementary Leverage Ratio (SLR) is equivalent to Basel III Tier-1 leverage ratio and varies from 3-5% for US banks. Under the relief program last April, the Fed allowed US banks to exclude holdings of US Treasury Bonds and cash kept in reserves at the Fed from their assets when calculating this ratio. The SLR relief is planned to end March 31, 2021. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations