Monetary

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Chart 2Global Manufacturers' Prices Moving Higher These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View Chart 8Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Chart 10Wider Vaccine Distribution Will Support Gold Demand Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Chart 12 Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Bond Market Performance: Government bonds in the developed economies are currently trapped in ranges, consolidating the sharp upward moves seen in the first quarter of 2021. This is only a pause in the broader cyclical uptrend, however, with central banks under increasing pressure to turn less dovish amid surging inflation and tightening labor markets. Oversold USTs: Technical indicators of yield/price momentum and investor sentiment/positioning suggest that US Treasuries are oversold. Working off this condition can take another 2-3 months, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation for Australian government bonds to overweight on a tactical (0-6 months) investment horizon. Feature Dear Client, Next week, in lieu of our regularly weekly report, I will be hosting a webcast on Tuesday, June 15 where I will discuss the outlook for global fixed income markets in the second half of 2021. Following that, we will be jointly publishing our bi-annual Global Central Bank Monitor Chartbook with our colleagues at BCA Research Foreign Exchange Strategy on Friday, June 18th. We will return to our regular publishing schedule on Tuesday, June 29th. Best Regards, Rob Robis Chart of the WeekA Tale Of Two Quarters The performance of government bond markets in the developed world so far in 2021 has been a tale of two quarters. In Q1, yields were rising steadily on the back of upside surprises in global growth and emerging signs of the biggest inflation upturn seen in nearly a generation. The Bloomberg Barclays Global Treasury index delivered a total return of -2.7% (hedged into US dollars) during the quarter, with no country escaping losses (Chart of the Week). The biggest declines were seen in the UK (-7.5%) the US (-4.3%), with the smallest losses occurring in Japan (-0.3%) and Italy (-0.7%). Chart 2Lower Vol Means High Yielders Outperform Low Yielders Q2 has been a different story, however. Yields have retreated somewhat from the year-to-date peaks seen at the end of Q1, leading to positive returns so far in Q2 in the UK (+0.8), the US (+1.2%) and Australia (+1.1%). The laggards are the low yielding euro area markets, most notably Italy (-0.7%) and France (-0.9%), that have seen yields move higher on the back of accelerating European growth. The Q2 returns look very much like a carry-driven market, with higher-yielding markets outperforming lower-yielding ones. That trend can persist if the current backdrop of low market volatility persists (Chart 2), although this calm will eventually be broken by a shift towards less dovish monetary policies. Some countries will make that shift at a faster pace than others, leading to relative value opportunities for bond investors in the latter half of 2021. This week, we discuss one such opportunity – Australia versus the US. US Treasuries: Oversold & Trendless – For Now After reaching a 2021 intraday high of 1.77% back on March 30, the benchmark 10-year US Treasury yield has traded in a narrow 15bp range between 1.55% and 1.70%. From a fundamental perspective, US yields are lacking direction because inflation expectations have already made a major upward adjustment to the more inflationary backdrop, but real yields have remained depressed by the continued dovish messaging from the Fed – for now - with regards to the timing of tapering or future rate hikes. From a technical perspective, however, the sideways pattern for US Treasury yields is also consistent for a market that trying to work off an oversold condition. Most of the technical indicators for the US Treasury market that we monitor regularly were at or close to the most bearish/oversold extremes seen since 2000 (Chart 3): Chart 3US Treasuries Are Working Off An Oversold Condition The 10-year Treasury yield is 39bps above its 200-day moving average, but that gap was as high as 84bps on March 19; The 26-week total return of the 10-year Treasury is -4.7%, after reaching a low of -8.8% on March 19; The JP Morgan client survey of bond managers and traders shows some of the largest underweight duration positioning in the 19-year history of the series; The Market Vane index of sentiment for Treasuries is in the bottom half of the range that has prevailed since 2000; The CFTC data on positioning in 10-year Treasury futures is the only one of our indicators that is not signaling an oversold market, with a small net long position of +3% (scaled by open interest). The overall message of these indicators suggests that price momentum and positioning reached such a bearish extreme by mid-March that some pullback in Treasury yields was inevitable. However, a look back at past periods when Treasuries became heavily oversold since the turn of the century shows that the duration and magnitude of such a pullback is highly variable – anywhere from two months to ten months. The main determining factors are the trends in economic growth and inflation in the US, and the Fed’s expected policy response to both. To show this, we conducted a simple study, updating work we first presented in a 2018 report.1 We looked at “oversold episodes” since 2000, which began when the 10-year Treasury yield was trading at least 50bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield subsequently converged back to its 200-day moving average. We then looked at the length of the episode (in days), and the change in bond yields, for each oversold episode. There were nine such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we rank the episodes by the number of days it took to complete each one, based on our simple moving average rule. We also show the change in both the 10-year Treasury yield and its 200-day moving average during each episode, to show how the convergence between the two unfolds. Table 1A Look At Prior Episodes Of An Oversold Treasury Market To describe the US economic backdrop during each episode, we looked at the change in the ISM manufacturing index and core PCE inflation during those oversold periods. We also show changes in two important determinants of the level of Treasury yields: inflation expectations using 10-year TIPS breakeven rates, and Fed rate hike expectations using our 12-month Fed discounter which measures the expected change in interest rates - one year ahead - priced into the US overnight index swap (OIS) curve. At the bottom of the table, we show the average for all nine oversold episodes, as well as the averages for the episodes were the ISM was rising and where core PCE inflation was rising. Chart 4US Treasury Market Oversold Episodes: 2003-2007 There are a few messages gleaned from the results in Table 1: The longest correction of an oversold Treasury market since 2000 took place between February 2018 and December 2018, when 305 days passed before the 10-year yield fell back to its 200-day moving average; The shortest correction was between June 2007 and August 2007, where only 52 days elapsed; Treasury yields typically decline during oversold periods, with two notable exceptions: 2018 and 2013/14, which were also the two longest episodes; During all of the oversold periods, markets reduced the amount of expected Fed tightening by an average of 26bps. However, that was entirely concentrated in four of the nine episodes - including three of the four shortest episodes – and is typically associated with a decline in inflation expectations. Growth momentum appears to be a bigger factor than inflation momentum in determining the length of an oversold episode, with longer episodes typically occurring alongside a rising ISM index, and vice versa. The notable exception was the longest episode in 2018, where the ISM declined by six points, although the bulk of that decline occurred in a single month at the end of the period (November 2018). For the more visually oriented, we present the time series for all the data in Table 1, shaded for the oversold periods, in Chart 4 (for the 2003-2007 period), Chart 5 (2008-2012), Chart 6 (2013-2017) and Chart 7 (2018 to today). We’ve added one additional variable – our Fed Monitor, designed to signal the need for tighter or looser US monetary policy – in the bottom panel of each of those charts. Chart 5US Treasury Market Oversold Episodes: 2008-2012 Chart 6US Treasury Market Oversold Episodes: 2013-2017 Chart 7US Treasury Market Oversold Episodes: 2018 To Today What does this look back tell us about looking ahead? The current episode, at only 105 days old, is still 62 days “younger” than the average oversold period, and 76 days “younger” than the average period where core inflation was rising. This would put the end of the current episode sometime in August. The ISM is essentially unchanged over the current episode so far, making it difficult to draw conclusions based on growth momentum – although the longest episode in 2018 shows that yields can trade sideways for a long time, even in the absence of a big slowing of growth, if the Fed is in a rate hiking cycle. However, the current episode differs dramatically from others in this analysis on two critical fronts. Core inflation has surged 1.6 percentage points since the oversold period began in February, far more than any other episode, while the gap between a rapidly increasing Fed Monitor and a flat 12-month Fed Discounter is also unique among post-2000 oversold periods. In other words, the Treasury market is still vulnerable to a repricing of Fed tightening expectations, especially with positioning and sentiment measures like the Market Vane survey and net futures positioning not yet at fully bearish extremes. Bottom Line: The current oversold condition in the US Treasury market can take another 2-3 months to unwind, based on an analysis of past oversold episodes. Beyond that, higher yields loom with the Fed starting to prepare the markets for a taper in 2022. Stay underweight Treasuries in global bond portfolios on a cyclical basis. RBA Checklist Update: No Case For A Hawkish Turn Yet Australia has been one of the top performing government bond markets within the developed economies, as discussed earlier. This performance has occurred even with strong acceleration of both Australian economic momentum and market-based inflation expectations (Chart 8). Despite our RBA Monitor flashing pressure on the RBA to tighten, and the Australian OIS curve already discounting 48bps of rate hikes over the next two years, Australian bond yields have remained very well behaved during the “calm” second quarter for global fixed income. Chart 8RBA Policies Limiting Rise In Bond Yields Chart 9RBA Stimulus Takes Many Forms The continued dovish messaging from the Reserve Bank of Australia (RBA) is the main reason for the solid Australia bond performance. The central bank is signaling no imminent shift in its combination of 0.1% nominal policy rates, deeply negative real rates, yield curve control on 3-year bonds and quantitative easing on longer-maturity bonds (Chart 9). Other central banks are starting to inch towards reining in the massive monetary accommodation of the past year. Could the RBA be next? In a Special Report published back in January of this year, we outlined a list of variables to watch to determine when the Reserve Bank of Australia (RBA) could be expected to turn less dovish.2 This checklist would also inform our country allocation view on Australian government bonds, which has remained neutral. A quick update on the latest readings from the RBA Checklist shows little pressure on the RBA to begin preparing markets for tighter monetary policy. 1. The vaccination process goes quickly and smoothly We are NOT placing a checkmark next to this part of our RBA Checklist. Australia has weathered COVID-19 far better than most other Western countries in terms of actual cases and deaths, but the vaccine rollout Down Under has been underwhelming. Only 16% of the population has received at least one vaccine jab, while a mere 2% is fully vaccinated. These are numbers that are more comparable to pandemic-ravaged emerging market countries like India and Brazil where access to vaccines is an issue (Chart 10). Chart 10A Slow Vaccine Rollout Down Under The slow vaccine rollout is less worrisome in light of the Australian government having secured enough vaccine doses to inoculate the entire population, and with the domestic economy facing limited remaining COVID-19 restrictions. The issue has been distribution and that is now occurring at a quickening pace. Until a much greater share of the population is vaccinated, however, Australia will continue to maintain aggressive COVID-related international travel restrictions – the government just announced that borders will remain shut until mid-2022 - that will be a major drag on the economically-important tourism sector. 2. Private sector demand accelerates alongside fiscal stimulus (✔) We ARE placing a checkmark next to this part of our RBA Checklist. Australia’s fiscal stimulus in response to the pandemic was one of the largest in the developed world. The stimulus was heavily focused on wage subsidies and income support measures like the JobSeeker program, which expired back in March. As the expensive stimulus programs are unwound, it is critical that the domestic economy can stand on its own without support. On that front, the news is good. Australia’s economy grew by 1.8% during Q1/2021, lifting the level of real GDP above the pre-pandemic peak (Chart 11). Both consumer spending and business investment posted solid growth during the quarter, fueled by surging confidence with the NAB business outlook measure hitting a record high in May (bottom panel). As a sign that the domestic economy is benefitting from a return to pre-pandemic habits, Q1 saw a 15% increase in spending in hotels, cafes and restaurants. That strength looked to extend into the Q2, with retail sales rising 1.1% in April, suggesting that Australian domestic demand is enjoying strong upward momentum. Chart 11A Confidence-Led Recovery In Domestic Demand Chart 12China Is A Drag On Australian Exports 3. China reins in policy stimulus by less than expected We are NOT placing a checkmark next to this part of our RBA Checklist. China is by far Australia’s largest trading partner, so Chinese demand is always an important contributor to Australian economic growth. This is why we included a China element in our RBA Checklist. Specifically, we deemed the outcome that would potentially turn the RBA more hawkish would be Chinese policymakers pulling back monetary and fiscal stimulus by less than expected in 2021 after the big policy support in 2020. The combined fiscal and credit impulse for China has already slowed by 9% of GDP since December 2020, signaling a meaningful cooling of Chinese growth in the latter half of 2021 that should weigh on demand for imports from Australia (Chart 12). However, Chinese import demand has already been severely impacted because of worsening China-Australia political tensions, which has led Beijing to impose restrictions on Australian imports for a variety of products, include coal, wine, beef, barley and cotton. The result is that there has been no growth in Australian total exports to China over the past year – an outcome that was flattered by the surge in iron ore prices - which has weighed on overall Australian export growth. Given this weak starting point for Chinese demand for Australian goods, the sharp reduction in the China stimulus is, on the margin, a factor that will not force the RBA to turn less dovish sooner than expected. 4. Inflation, both realized and expected, returns to the RBA’s 2-3% target We are NOT placing a checkmark next to this part of our RBA Checklist. Australian inflation remains well below the RBA’s 2-3% target range, with the headline CPI and the less volatile trimmed mean CPI both expanding at only a 1.1% annual rate in Q1/2021 (Chart 13). The RBA is forecasting a brief boost to both measures in Q2, before settling back below 2% to the end of 2022. Chart 13No Bond-Bearish RBA Policy Shift Without More Inflation Chart 14Diminishing Financial Stability Risks From Housing The RBA’s message on the inflation outlook has been very consistent. A sustainable move of realized inflation back to the 2-3% target range – that would prompt a normalization of monetary policy – cannot occur without a significant tightening of labor markets that drives wage growth back to 3% from the Q1/2021 reading of 1.5%. The RBA currently does not expect that outcome to occur before 2024. The RBA believes that the full employment NAIRU is between 4-4.5%, well below the OECD’s latest estimate of 5.4%. Given the sharp drop in Australian unemployment already seen over the past few quarters, there is the potential for an upside surprise in the wage data that could lead the RBA to change its policy bias. The central bank would need to see a few quarters of such wage surprises, however, before altering its forward guidance on the timing of future rate hikes. 5. House price inflation begins to accelerate We are NOT placing a checkmark next to this part of our RBA Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets were overheating could prompt the RBA to consider tighten monetary policy. The annual growth of median house prices has dipped from +8% in Q1 2020 to +4% in Q4 2020, despite robust housing demand as evidenced by the 40% growth in building approvals. At the same time, housing valuations have become less stretched with the ratio of median home prices to median household incomes falling -9% from the 2017 peak according to data from the OECD (Chart 14). The RBA remains sensitive to the potential financial stability risks from overvalued housing. The latest trends in the house price data, however, suggest that the central bank does not yet to have the use the blunt tool of tighter monetary policy to cool off an overheated housing market. Chart 15Upgrade Australia To Overweight (Vs. USTs) In sum, the majority of items in our RBA Checklist are signaling no immediate pressure on the central bank to tighten policy. The first 25bp rate hike is not discounted in the Australian OIS curve until April 2023, a little ahead of RBA guidance but still consistent with a very dovish policy bias. The inflation data, in our view, will be the critical factor that could prompt the markets to pull forward expected monetary tightening, leading to a surge in Australian bond yields. With the RBA already expecting a surge in inflation in the Q2/2020 data, the central bank would likely want to see at least a couple of more quarterly inflation prints – both for the CPI and wage price index - before signaling a more hawkish policy shift. Thus, the RBA will likely stay dovish over the latter half of 2021 Therefore, we are moving to an overweight recommended stance on Australian government bonds on a tactical (0-6 months) basis. In our model bond portfolio on pages 16-17, we are “funding” that shift to an above-benchmark weighting in Australia out of US Treasury exposure. Given our view that the Fed will soon begin to signal a 2022 taper of its asset purchases, relative policy dovishness should lead Australian government bonds to outperform US Treasuries in the latter half of this year. In addition, Australian bonds have a lower yield beta to changes in US Treasury yields, relative to the high beta to changes in non-US developed market yields (Chart 15), making allocations out of the US into Australia attractive from a risk management perspective in a global bond portfolio. Bottom Line: Only one of the five components of our “RBA Checklist” – designed to measure the pressures that would force the Reserve Bank of Australia to turn less dovish – is flashing such a signal. We are upgrading our recommended allocation to Australian government bonds to overweight on a tactical investment horizon.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 See BCA Research Global Fixed Income Strategy Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20, 2018. 2 See BCA Research Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Tracking Nonfarm Payrolls With 12-month PCE inflation already above the Fed’s 2% target, it is progress toward the Fed’s “maximum employment” goal that will determine both the timing of Fed liftoff and whether bond yields rise or fall. On that note, the bond market is currently priced for Fed liftoff in early 2023. We also calculate that average monthly nonfarm payroll growth of between 378k and 462k is required to meet the Fed’s “maximum employment” goal by the end of 2022, in time for an early-2023 rate hike. It follows from this analysis that any monthly employment print above +462k should be considered bond-bearish and any print below +378k should be considered bond-bullish (Chart 1). In that light, May’s +559k print is bond-bearish, and we anticipate further bond-bearish employment reports in the coming months as COVID fears fade and people return to a labor market that is already awash with demand. Investors should maintain below-benchmark portfolio duration in US bond portfolios and also continue to favor spread product over duration-matched Treasuries. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 47 basis points in May, bringing year-to-date excess returns up to +159 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. At 142 bps, the 2/10 Treasury slope is very steep and the 5-year/5-year forward TIPS breakeven inflation rate sits at 2.27% - almost, but not quite, within the 2.3% to 2.5% range that the Fed considers “well anchored”.1 The message from these two indicators is that the Fed is not yet ready for monetary conditions to turn restrictive. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is almost at its lowest since 1995 (Chart 2). Though we retain a positive view of spread product as a whole, tight valuations cause us to recommend only a neutral allocation to investment grade corporates. We prefer high-yield corporates, municipal bonds and USD-denominated Emerging Market Sovereigns. Last week, the Fed announced that it will wind down its corporate bond portfolio over the coming months. The corporate bond purchase facility has not been operational since December 2020, meaning that the corporate bond market has been functioning without an explicit Fed back-stop for all of 2021. The portfolio itself is also quite small compared to the size of the corporate bond market. As a result, we anticipate no material impact on spreads. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +343 bps. In a recent report, we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.3% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s corporate debt binge will moderate in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4%, very close to what is priced into junk spreads. Given that the large amount of fiscal stimulus coming down the pike makes the Fed’s 6.5% real GDP growth forecast look conservative, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in May, dragging year-to-date excess returns down to -9 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 7 bps in May. The spread remains wide compared to recent history, but it is still tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) currently sits at 24 bps. This is considerably below the 51 bps offered by Aa-rated corporate bonds and the 27 bps offered by Agency CMBS. It is only slightly more than the 18 bps offered by Aaa-rated consumer ABS. All in all, value in MBS is not appealing compared to other similarly risky sectors. In a recent report, we looked at MBS performance and valuation across the coupon stack.3 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be flat-to-higher during the next 6-12 months, we recommend favoring high coupons over low coupons within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +87 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 32 bps in May, bringing year-to-date excess returns up to +53 bps. Foreign Agencies outperformed the Treasury benchmark by 2 bps on the month, bringing year-to-date excess returns up to +37 bps. Local Authority bonds outperformed by 30 bps in May, bringing year-to-date excess returns up to +360 bps. Domestic Agency bonds and Supranationals both outperformed by 8 bps, bringing year-to-date excess returns up to +27 bps and +24 bps, respectively. We recently took a detailed look at USD-denominated Emerging Market (EM) Sovereign valuation.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Indonesia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space where there is still some value left in US corporate spreads and where the EM space is dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 21 basis points in May, dragging year-to-date excess returns down to +286 bps (before adjusting for the tax advantage). We took a detailed look at municipal bond performance and valuation in a recent report and came to the following conclusions.5 First, the economic and policy back-drop is favorable for municipal bond performance. The recently enacted American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that comes after state & local government revenues already exceeded expenditures in 2020 (Chart 6). President Biden has also proposed increasing income tax rates. However, there may not be time to pass these tax hikes before the 2022 midterm elections. Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down in quality to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates. GO munis offer a breakeven tax rate of just 7% (panel 2). Fourth, taxable munis offer a yield advantage over investment grade corporates that investors should take advantage of (panel 3). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 22% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them prone to extension risk if bond yields gap higher. Treasury Curve: Buy 5-Year Bullet Versus 2/30 Barbell Chart 7Treasury Yield Curve Overview Treasury yields fell in May, with the 5-10 year part of the curve benefiting the most. The 7-year yield fell 8 bps in May while the 5-year and 10-year yields both fell 7 bps. Yield declines were smaller for shorter (< 5-year) and longer (> 10-year) maturities. The 2/10 Treasury slope flattened 5 bps to end the month at 144 bps. The 5/30 Treasury slope steepened 3 bps to end the month at 147 bps (Chart 7). We recently changed our recommended yield curve position from a 5 over 2/10 butterfly to a 5 over 2/30 butterfly.6 In making the switch we noted that the slope of the Treasury curve has behaved differently since bond yields peaked in early April. Prior to April, the rise in bond yields was concentrated at the very long-end (10-year +) of the curve. During the past two months, the belly of the curve (5-7 years) has seen more volatility. We conclude that we are now close enough to an expected Fed liftoff date that further significant increases in yields will be met with a flatter curve beyond the 5-year maturity point and that the 5-year and 7-year notes are likely to benefit the most if bond yields dip. We also observe an exceptional yield pick-up of +33 bps in the 5-year bullet over a duration-matched 2/30 barbell. Given our view that bond yields will be flat-to-higher during the next 6-12 months, we recommend buying the 5-year bullet over a duration-matched 2/30 barbell to take advantage of the strong positive carry in a flat yield environment, and as a hedge against our below-benchmark portfolio duration stance. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 86 basis points in May, bringing year-to-date excess returns up to +484 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 1 bp and 2 bps on the month, respectively. At 2.42%, the 10-year TIPS breakeven inflation rate is near the top-end of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.27%, the 5-year/5-year forward TIPS breakeven inflation rate is just below the target band (panel 3). With long-maturity breakevens already consistent (or close to consistent) with the Fed’s target, they have limited upside going forward. The Fed has so far welcomed rising TIPS breakeven inflation rates, but it will have an increasing incentive to lean against them if they continue to move up. We also think that the market has priced-in an overly aggressive inflation outlook at the front-end of the curve. The 1-year and 2-year CPI swap rates stand at 3.76% and 3.12%, respectively. There is a good chance that these lofty inflation expectations will not be confirmed by the actual data. With all that in mind, investors should maintain a neutral allocation to TIPS versus nominal Treasuries and also a neutral posture towards the inflation curve (panel 4). The inflation curve could steepen somewhat in the near-term if short-maturity inflation expectations moderate, but we expect the curve to remain inverted for a long time yet. An inverted inflation curve is more consistent with the Fed’s Average Inflation Target than a positively sloped one, and it should be considered the natural state of affairs moving forward. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in May, bringing year-to-date excess returns up to +33 bps. Aaa-rated ABS outperformed by 13 bps on the month, bringing year-to-date excess returns up to +26 bps. Non-Aaa ABS outperformed by 12 bps on the month, bringing year-to-date excess returns up to +70 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. This excess savings has still not been spent and, already, the most recent round of stimulus checks is pushing the savings rate higher again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 41 basis points in May, bringing year-to-date excess returns up to +163 bps. Aaa Non-Agency CMBS outperformed Treasuries by 27 bps in May, bringing year-to-date excess returns up to +78 bps. Non-Aaa Non-Agency CMBS outperformed by 84 bps, bringing year-to-date excess returns up to +453 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to weaken and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 37 basis points in May, bringing year-to-date excess returns up to +125 bps. The average index option-adjusted spread tightened 7 bps on the month and it currently sits at 27 bps (bottom panel). Though Agency CMBS spreads have completely recovered their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 28TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 28TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 28TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For further discussion of how we assess the state of monetary policy vis-à-vis spread product please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 3 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021. 5 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 6 Please see US Bond Strategy Weekly Report, “Entering A New Yield Curve Regime”, dated May 11, 2021.