Policy

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

Special Report

Highlights The Fed: The Fed will formally discuss tapering plans over the course of this summer and fall and announce the slowing of asset purchases before the end of 2021. Its labor market objectives will also be achieved in time to lift rates in 2022. Non-US Developed Markets: The central banks outside the US most likely to deliver tapering and/or outright rate hikes over the next 1-2 years are those facing housing bubbles – the Bank of Canada and Reserve Bank of New Zealand. The ECB will do nothing on rates while adjusting asset purchase programs to preserve the size of its balance sheet, while the Reserve Bank of Australia will also sit on their hands for longer. Bond Strategy Recommendations: Investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor exposure in markets where central banks will be more dovish than expected (core Europe, Australia), while limiting exposure to markets where hawkish surprises are more likely (the US, Canada, New Zealand). Feature The recovery from the 2020 COVID recession is now well underway and many investors are getting antsy about when central bankers might respond by removing monetary policy accommodation. Some central banks appear more eager than others. Both the Bank of Canada and Bank of England, for instance, have already started to reduce their rates of bond buying. Meanwhile, the US Federal Reserve is only just now starting to talk about the timing of its own tapering. This Special Report lays out a timeline for what central bank actions we should expect during the next two years. The first section focuses exclusively on the US Federal Reserve and the second section incorporates likely announcements from other central banks. Based on a comparison of our expected central bank timeline with current market prices, we conclude that investors should maintain below-benchmark portfolio duration in US-only and global fixed income portfolios. Global bond investors should also favor government bonds in countries where central banks are likely to be less hawkish than markets expect (core Europe, Australia) versus bonds from countries where hawkish surprises are more likely (US, Canada, New Zealand and, potentially, the UK and Sweden).   The Federal Reserve’s Timeline Chart 1 shows our anticipated timeline for when the Federal Reserve will make specific policy announcements between now and the start of 2024. Chart 1The Federal Reserve’s Timeline First, over the course of this summer, the Fed will initiate discussions about when to taper its asset purchases. Then, asset purchase tapering will be announced at the December 2021 FOMC meeting with purchases set to decline as of the beginning of 2022. We expect that net Fed purchases will fall to zero by the end of Q3 2022. That is, by that time the Fed will no longer be adding to its securities holdings. Rather, it will keep the size of its balance sheet constant. Then, with its balance sheet no longer growing, the Fed will begin the process of lifting interest rates. We expect the first rate hike to occur at the December 2022 FOMC meeting. Finally, some time after the fed funds rate is well above the zero bound, the Fed will try to reduce the size of its securities portfolio. How do we arrive at this timeline? Table 1A Checklist For Liftoff We start with the Fed’s forward guidance about the timing of the first rate hike (Table 1). The Fed has told us that it will lift rates off the zero bound once (i) PCE inflation is above 2%, (ii) the labor market is at “maximum employment” and (iii) inflation is expected to remain above 2% for some time. The first item on the Fed’s liftoff checklist has already been met and the third item logically follows from the other two. That is, if inflation is above 2% and the labor market is at “maximum employment” then the Fed will certainly expect inflation to remain high. This means that the second item on the Fed’s checklist is the most critical for assessing the timing of liftoff. In assessing the US labor market’s progress toward “maximum employment” we first have to define what “maximum employment” means. Based on the Fed’s communications, we infer that “maximum employment” means an unemployment rate between 3.5% and 4.5% - a range consistent with the Fed’s NAIRU estimates – and a labor force participation rate that has recovered back to pre-pandemic levels (Chart 2). Table 2 presents the average monthly growth in nonfarm payrolls that is required to reach that definition of maximum employment by specific future dates. For example, we calculate that average monthly payroll growth of 698k to 830k will cause the labor market to reach maximum employment by the end of this year. Average monthly payroll growth of 412k to 493k is required to hit the Fed’s target by the end of 2022. Chart 2Defining "Maximum Employment" Table 2Average Monthly Nonfarm Payroll Growth Required To Reach Maximum Employment By The Given Date The most recent issue of the Bank Credit Analyst posits several reasons why US employment growth will pick up steam in the coming months.1 We agree with this view and note that indicators of labor demand such as job openings, the NFIB “jobs hard to get” survey and the Conference Board’s “jobs plentiful” survey also point to accelerating employment gains.2 All told, we think that average monthly payroll growth of 412k to 493k is eminently achievable (Chart 3). This means that the Fed will hit its three liftoff criteria in time to hike rates before the end of 2022. Chart 3Max Employment By The End of 2022 Working backwards from the expected liftoff date, the Fed has said that it needs to see “substantial progress” toward the criteria listed in Table 1 before it will taper its pace of asset purchases. The definition of “substantial progress” remains somewhat unclear, but a few recent Fed communications provide some clues. First, Fed Chair Jay Powell said that he wants to see a “string of months” like the strong March employment report before it will be appropriate to reduce the pace of asset purchases. The question of how many months constitutes a “string” remains unclear, but it certainly seems plausible that we could see two or three more strong employment reports over the course of the summer. Other Fed Governors appear to agree with this timeline. Governor Randal Quarles: If my expectations about economic growth, employment, and inflation over the coming months are borne out, however, and especially if they come in stronger than I expect, then, as noted in the minutes of the last FOMC meeting, it will become important for the FOMC to begin discussing our plans to adjust the pace of asset purchases at upcoming meetings.3 Fed Vice-Chair Richard Clarida: I myself think that the pace of labor market improvement will pick up. […] It may well be the time that – there will come a time in upcoming meetings we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases …4 Fed Governor Christopher Waller: The May and June jobs report[s] may reveal that April was an outlier, but we need to see that first before we start thinking about adjusting our policy stance.5 Our takeaway from these comments is that two or three more strong employment reports, say 500k or higher, would be sufficient for the Fed to more formally discuss tapering plans. Further, several Fed Governors seem to agree with our forecast that nonfarm payroll growth will accelerate in the coming months. With that in mind, it seems reasonable to expect that the Fed will discuss tapering plans over the course of the summer and fall, and that it will have seen sufficient labor market gains to announce a formal plan before the end of this year. Assuming that a tapering announcement occurs before the end of this year and that asset purchases actually start declining as of Jan 1st 2022, we estimate that the tapering process will conclude by the end of Q3 2022. That is, the Fed will hold the size of its balance sheet constant as of that date. Chart 4Balance Sheet Growth Will End Before The First Rate Hike At the very least, the Fed will certainly bring its net purchases to zero before it lifts rates. This is because it would be incoherent for the Fed to be tightening policy through its interest rate actions while it eases policy with its balance sheet strategy. Indeed, this is the roadmap that the Fed followed leading up to the 2015 rate hike cycle (Chart 4). Finally, we note that the Fed will try to reduce the size of its balance sheet only after the process of rate hikes is well underway. This will be consistent with the last tightening cycle when the Fed waited until the funds rate was 1.5% before it pared the size of its securities portfolio (Chart 4). We also want to stress that the Fed will only try to reduce the size of its balance sheet. In fact, we doubt that this process will get very far. The main reason for our skepticism is that there is an ongoing structural issue in the Treasury market where the supply of securities keeps growing while stricter regulations make it more costly for primary dealers to intermediate trades.6 In this environment, there are strong odds that Treasury market liquidity will evaporate whenever there is a significant shock to financial markets. When that happens, the Fed will be forced to support Treasury market liquidity through large-scale purchases, as was the case during last March’s market turmoil (Chart 5). In essence, the likelihood of future shocks that will necessitate Fed intervention in the Treasury market makes it unlikely that the Fed will make much progress reducing the size of its balance sheet. Chart 5Fed Had To Support Treasury Market In March 2020 Market Expectations And Investment Implications We can get a sense of how our Fed timeline compares to consensus expectations by looking at the New York Fed’s Surveys of Market Participants and Primary Dealers (Tables 3A & 3B). Respondents to these surveys expect tapering to start in early 2022, in line with our expectations, though they generally see it taking longer for net purchases to fall to zero. Respondents also expect a later Fed liftoff date than we do and don’t see the Fed trying to reduce the size of its balance sheet until well after rate hikes have begun. Table 3ASurvey of Market Participants Expected Fed Timeline Table 3BSurvey Of Primary Dealers Expected Fed Timeline But more important for investors than survey results is what is currently priced into the yield curve. In that regard, the overnight index swap curve is priced for Fed liftoff in February 2023 and a total of 75 bps of rate hikes by the end of 2023 (Chart 6). We expect rate hikes to start earlier and proceed more quickly than that, and therefore recommend running below-benchmark duration in US bond portfolios. Chart 6Market Rate Expectations The Timelines For Other Central Banks Policymakers outside the US are facing many of the same issues that the Fed is – rapidly recovering economies coming out of the pandemic, inflation overshoots, and surging asset prices. However, not every central bank will respond at the same time, or same pace, as the Fed. In Charts 7a and 7b, we show additional timelines for two of the most important non-Fed central banks: the European Central Bank (ECB) and the BoE. We see the likely dates and policy decisions playing out as follows. Chart 7AThe ECB’s Timeline Chart 7BThe Bank Of England’s Timeline European Central Bank For the ECB, the timing of its upcoming inflation strategy review is the most critical element. That report is due to be delivered in the latter half of this year, most likely in September or October (no firm release date has been announced by the ECB). It is highly unlikely that any meaningful policy changes will be implemented before that strategic review is completed. Some ECB officials have hinted that a move to a Fed-like interpretation of the ECB inflation target, tolerating overshoots of the target to make up for past undershoots, could result from the strategy review. The more likely option will be a move to an inflation target range, perhaps a 1-3% tolerance band, that offers more policy flexibility than the current target of just below 2%. This will potentially “move the goalposts” for the ECB in a way that will make monetary tightening even less likely compared to previous cycles. Looking at past ECB tightening episodes dating back to the central bank’s inception in 1998, it is clear that a majority of countries within the euro area must be seeing inflation that is high enough, with unemployment low enough, before any policy tightening can take place. Chart 8 illustrates this point, by showing “breadth” measures for unemployment and inflation across the euro area.7 Chart 8The ECB Usually Tightens When Growth AND Inflation Are Broad Based Specifically, the chart shows the percentage of euro area countries with an unemployment rate below the OECD’s estimate of full employment (second panel), the percentage of euro area countries with headline inflation higher than one year earlier (third panel) and the percentage of euro area countries with headline inflation above the ECB’s 2% target (bottom panel). We compare those breadth measures to the actual path of policy interest rates and the size of the ECB’s balance sheet (top panel). The conclusion from the chart is that the euro area is still a long way from having the sort of broad-based rise in inflation or fall in unemployment necessary to trigger a reduction in the size of its balance sheet or actual interest rate hikes. Chart 9The ECB Is Under No Pressure To Tighten Pre-Emptively Nonetheless, our expectation is that the ECB will want to begin preparing the markets for the end of the Pandemic Emergency Purchase Program (PEPP) - which has been buying government bonds since March 2020 in a less constrained fashion than previous asset purchase programs - shortly after the inflation strategy review is concluded. Much of the euro area economy is already showing signs of rapid recovery from pandemic induced lockdowns, amid an accelerating pace of vaccinations. On top of that, the Next Generation European Union (NGEU) recovery fund is set to begin distributing funds in the final quarter of 2021, providing a meaningful lift to government investment and expected growth in 2022. It will be difficult for the ECB to justify the need for an “emergency” program like the PEPP to continue against such a growth backdrop, especially with euro area inflation no longer at the depressed levels seen in 2020. We expect the ECB to begin preparing the market for the end of PEPP heading into the December 2021 ECB policy meeting, when it will be announced that the program will not be renewed when it expires in March 2022 (Chart 9). As always for such major policy announcements, the ECB will wish to do so when there is a new set of economic forecasts used to justify any changes. This is why December – the first meeting after the strategic review is completed that will also have new forecasts – is the earliest realistic date for an announcement on the PEPP. The communication around the PEPP announcement will need to be delicate, as the PEPP has significantly increased the ECB’s footprint in European bond markets. The share of government bonds owned by the ECB has increased by anywhere from five to ten percentage points since the PEPP began (Chart 10). We expect the ECB will be forced to expand its existing Public Sector Purchase Program (PSPP) to make up for the eventual disappearance of the PEPP. This means that the PEPP will be effectively “rolled into” the PSPP, to limit the damage from a likely post-PEPP surge in bond yields in the more fragile markets like Italy, Spain and even Greece – especially with the euro now trading close to pre-2008 highs on a trade-weighted basis (Chart 11). Chart 10The PEPP Can Expire, But Cannot Disappear Chart 11ECB Must Avoid A 'PEPP Taper Tantrum' There is a chance that the ECB will want to avoid any “PEPP taper tantrum” in Peripheral European yields (and spreads versus Germany) by making an announcement on PEPP expiry and PSPP expansion at the same meeting. If that happens, we suspect it would happen in December of this year rather than sometime in the first quarter of 2022. Beyond that, the ECB will likely seek to keep financial conditions as accommodative as possible by keeping policy interest rates unchanged well into 2023, with an actual rate hike not likely until mid-2024 at the earliest. The ECB could deliver a more modest form of “tightening” before then by letting some of the cheap bank funding programs (TLTROs) expire. Although we suspect that even those programs will need to be renewed, perhaps at less attractive financing terms, to prevent an unwanted tightening of credit conditions in the euro area banking system. Bank Of England Chart 12BoE Forecasts Are Conservative Having already announced a tapering of the pace of its bond buying in early May, the BoE is likely to continue along that path over the next year. We expect the BoE, like the ECB, to make any future taper announcements when new sets of economic forecasts are published in Monetary Policy Reports. Thus, the next taper announcements are expected in August 2021, November 2021 and February 2022, with a full tapering down to zero net purchases (new buying only replacing maturing bonds) by May 2022 at the latest. The first rate hike will occur between 6-12 months after the end of tapering, possibly as early as November 2022 but, more likely in our view, sometime closer to mid-2023. The most recent set of BoE economic forecasts calls for headline UK CPI inflation to rise to 2.3% in 2022 before settling down to 2% in 2023 and 1.9% in 2024 (Chart 12). This would be a mild inflation outcome by recent UK standards during what will certainly be a period of strong post-pandemic growth over the next 12-18 months. Longer-term inflation expectations, both survey-based and extracted from CPI swaps and inflation-linked Gilts, are priced for a bigger inflation upturn above 3%. The BoE has been one of the least active central banks in the developed world since the 2008 financial crisis. The BoE main policy rate, the Bank Rate, has been no higher than 0.75% since then, even with the BoE threatening to lift rates to higher levels many times under the leadership of former Governor Mark Carney when inflation was overshooting the bank’s 2% target. Of course, the Brexit uncertainty since mid-2016 effectively tied the hands of the central bank and prevented any possible policy tightening. Now that Brexit has actually happened, however, the BoE has more flexibility to respond to developments with UK economic growth and inflation, as needed. A possible path for the UK Cash Rate was laid out in a recent speech by BoE Monetary Policy Committee (MPC) member Gertjan Vlieghe.8 He triggered a selloff across the Gilt market with his comment that a BoE rate hike could occur as early as Q2 2022 – with the Bank Rate rising to 1.25% from the current 0.1% by 2024 - under more optimistic scenarios for UK growth and employment. His base case, however, was that the coming uptick in UK inflation will prove to be temporary, but that a move towards full employment will make the first hike more likely toward the end of 2022 with modest rate increases in 2023 and 2024 that will take the Bank Rate to 0.75% (Chart 13). Chart 13Gilts Are Vulnerable To A Hawkish Surprise Vlighe’s base case scenario on growth and interest rates is in line with the BoE’s current forecasts that call for spare capacity in the UK economy to be fully eliminated by mid-2022, with rate hikes to begin in mid-2023. That is broadly in line with our projected BoE timeline and with current pricing in the UK OIS curve, although we see risks tilted towards faster growth and inflation – and the BoE moving more aggressively than projected – over the next 12-18 months. Other Major Developed Market Central Banks Looking beyond the “Big Three” of the Fed, ECB and BoE, central bank timelines have become increasingly dependent on a single factor – the strength of domestic housing markets. House prices are booming in Canada, New Zealand and Sweden, with valuation measures like the ratio of median house prices to median incomes soaring to historical extremes according to the OECD (Chart 14). House prices are also climbing fast in the US and UK, but the valuation measures have not surpassed the peaks seen during the mid-2000s housing bubble. The housing boom has already motivated some central banks to respond by turning less dovish sooner than expected, even with unemployment rates still above pre-pandemic peaks (Chart 15).9 The BoC noted that soaring Canadian housing values motivated the taper announcement in April. The Reserve Bank of New Zealand (RBNZ) has come under political pressure over the growing unaffordability of New Zealand homes, with the government changing the central bank’s remit earlier this year to force the RBNZ to explicitly consider house price inflation when setting monetary policy. Chart 14Surging House Prices Can Turn Doves Into Hawks Chart 15These CBs Could Turn More Hawkish Before Reaching Full Employment We expect more tapering announcements from the BoC over the latter half of 2021, with a first rate hike likely sometime in the first quarter of 2022. We see the RBNZ moving aggressively, as well, tapering over the remainder of 2021 before lifting rates by the spring of 2022 at the latest. Sweden’s Riksbank will be the next central bank to turn more hawkish because of surging home values, although they will lag the pace of the BoC and RBNZ with Sweden only now beginning to emerge from lockdowns associated with a third wave of COVID-19 cases. Importantly, Australia – a country that has dealt with house price surges in the past – has seen house price valuations retreat over the past few years, even with the Reserve Bank of Australia (RBA) slashing policy rates to historic lows. The RBA also introduced yield curve control in 2020 to anchor the level of short-term bond yields, while also engaging in outright bond purchases to mitigate the rise in longer-term bond yields. With Australian inflation still remaining well below target in a year of rising global inflation, and with subdued labor costs likely to keep price pressures moderate over the next 12-18 months, we expect the RBA to move very slowly on both tapering and rate hikes. Finally, for completeness, we should note that we do not expect any policy changes from the Bank of Japan (BoJ) over the next two years, with inflation likely to remain far below the central bank’s 2% target. Non-US Investment Implications In Table 4, we show the timing of the first rate hike (i.e. “liftoff”), and the subsequent amount of total rate hikes to the end of 2024, as currently discounted in the OIS curves of the eight countries discussed in this report. We rank the countries in the table in order of liftoff dates, starting with the closest to today. Table 4The “Pecking Order” Of Central Bank Rate Hikes The RBNZ is expected to hike first in May 2022, followed by the BoC (September 2022), the Fed (February 2023), the RBA (April 2023), the Riksbank (May 2023), the BoE (May 2023), the ECB (June 2023) and the BoJ (October 2025). The cumulative amount of rate hikes discounted to the end of 2024 rank similarly: more rate increases are expected in New Zealand (167bps), Canada (150bps), the US (137bps) and Australia (113bps); while fewer rate increases are expected in the Sweden (63bps), the UK (61bps), the euro area (31bps) and Japan (7bps). According to our various central bank timelines discussed in this report, we see the risks of a rate hike coming sooner than discounted by markets in the US, Canada and New Zealand. We see central banks moving slower than markets expect in the euro area and Australia, while we see Sweden and UK priced in line with our base case views (although we see risks tilted towards a more hawkish turn faster than expected in the latter two). The story is the same in terms of cumulative rate hikes discounted in OIS curves, with markets not pricing in enough rate hikes in New Zealand, Canada and the US – and, possibly, Sweden and the UK – while pricing too many hikes in Australia and the euro area. This leads us to recommend the following country allocations in a global government bond portfolio: Underweight the US, Canada and New Zealand Overweight Australia and core Europe (and Japan) Neutral Sweden and the UK, but with a bias to downgrade. Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst June 2021 Monthly Report, "Global House Prices: A New Threat For Policymakers", dated May 27, 2021. 2 Please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 3 https://www.federalreserve.gov/newsevents/speech/quarles20210526b.htm 4 https://ca.news.yahoo.com/federal-reserve-vice-chair-richard-clarida-yahoo-finance-transcript-may-2021-173007192.html 5 https://www.federalreserve.gov/newsevents/speech/waller20210513a.htm 6 For a longer discussion of Treasury market liquidity issues please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup 2: Shocked And Awed”, dated July 28, 2020. 7 For more details, please see Global Fixed Income Strategy Report, “ECB Outlook: Walking On Eggshells”, dated May 19, 2021. 8 The full speech can be found here: https://www.bankofengland.co.uk/speech/2021/may/gertjan-vlieghe-speech-hosted-by-the-department-of-economics-and-the-ipr 9 For more details on the global housing boom, see Global Fixed Income Strategy Special Report, “Global House Prices: A New Threat For Policymakers”, dated May 28, 2021. Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights House prices are rising rapidly across the developed markets, in response to the extraordinary monetary and fiscal policy stimulus implemented to fight the pandemic. Evidence points to the house price surge being driven by monetary policy that has left real interest rates far below equilibrium levels. Supply factors are a secondary cause of the house price boom. Financial stability risks stemming from rising house prices are less acute than the pre-2008 experience, as overall household leverage has grown more slowly during the pandemic and global banks are better capitalized. Rapidly rising house prices are forcing some central banks to turn less accommodative earlier than expected. The recent hawkish turns by the Bank of Canada and Reserve Bank of New Zealand may be canaries in the coal mine for other central banks – perhaps even the Fed – if house prices and household leverage start rising together. Feature The COVID-19 pandemic led to the sharpest economic recession since World War II, alongside an enormous rise in unemployment. Consensus expectations call for the output gap to be closed (or mostly closed) in most advanced economies by the end of this year, but it remains an open question how quickly these economies will be able to return to full employment amid potentially permanent shifts in demand for office space and goods sold at physical, “brick and mortar” retail locations. Despite this sizeable and swift economic shock, house price appreciation accelerated last year in the developed world. Chart 1 highlights that US house prices rose at an 18% annualized pace in the second half of 2020, whereas they accelerated at a high-single digit pace in developed markets ex-US (on a GDP-weighted basis). This, in conjunction with a sharp rise in the household sector credit-to-GDP ratio (Chart 2), has unnerved some investors while raising questions about the implications for monetary policy. Chart 1House Prices Are Surging Around The World Chart 2Rising Fears About Deteriorating Household Balance Sheets Before we discuss the investment implications of the global housing boom, however, we must first accurately determine the reasons why it is happening. The Work-From-Home Effect: Less Than Meets The Eye When analyzing the surprising behavior of the housing market last year, the working-from-home effect brought upon by the pandemic emerges as an obvious factor potentially explaining house price gains. Last year, following recommended or mandatory stay-at-home orders from governments, most office-based businesses rapidly shifted to work-from-home arrangements as an emergency response. However, in the month or two following the beginning of stay-at-home orders, several national US surveys found many office workers preferred the flexibility afforded by work-from-home arrangements. Many employers, correspondingly, found that the productivity of their employees did not suffer while working from home, or that it even improved. Several prominent corporations in the US have subsequently made some work-from-home options permanent, or even allowed employees to work from offices in a different city than they did prior to the pandemic. Newfound work-from-home options have undoubtedly created new demand for housing, and thus explained the surge in house prices seen over the past year in the minds of some investors. However, in our view, evidence from the US, the UK, and France suggests that the work-from-home effect better explains differences in price gains across housing types and within large metropolitan areas, rather than aggregate or national-level changes in house prices. Chart 3 provides some quantification of the impact of work-from-home policies by plotting US resident migration patterns by city. This data has been compiled by CBRE, and the impact of COVID is shown as the change in net move-ins from 2019 to 2020 per 1000 people. This helps control for the underlying migration pattern that existed in US cities prior to the pandemic. Chart 3Work From Home Policies Have Impacted Migration Trends… The chart highlights that the negative migration impact from COVID has been mostly concentrated in New York City and the three most populous cities on the West Coast (by metro area): Los Angeles, San Francisco, and Seattle. And yet, Chart 4 highlights that house price inflation in these four cities has accelerated to a double-digit pace, only modestly below the national average. Chart 4...But Cities With Outward Migration Still Have Very Strong House Price Gains The house price indexes shown in Chart 4 represent aggregate, metro area trends, and clearly some regions within these metro areas have experienced house price deceleration or outright deflation versus gains in areas outside the urban core. But Chart 5 highlights that house prices have declined in Manhattan basically in line with the change in net move-ins as a share of the population, underscoring that double-digit metro area-wide house price gains appear to be vastly disproportionate to changes in net migration. Similarly, Chart 6 highlights that rents decelerated in the US over the past year but remained in positive territory and grew at a 3.5% annualized rate from February to April. Chart 5In Manhattan, House Prices Have Tracked Net Migration Chart 6Rent Costs Have Decelerated, But Have Not Contracted Evidence from Paris and London also suggests that a work-from-home effect is insufficient to explain broad house price gains. Panel 1 of Chart 7 highlights that house prices in France have accelerated significantly, but that apartment prices have decelerated only fractionally in lockstep. Panel 2 shows that the acceleration in house prices does reflect a work-from-home effect, as prices have risen faster in inner Parisian suburbs. Panel 3, however, highlights that Parisian apartment prices, the dominant property type in the urban core, have decelerated modestly. Chart 8 highlights that house price gains have not even decelerated in greater London; they have been merely been modestly outstripped by gains in Outer South East (outside of the Outer Metropolitan Area). Chart 7In France, Parisian Apartment Prices Are Simply Lagging, Not Falling Chart 8In The UK, Greater London Property Prices Are Accelerating     The Policy Effect: The Fundamental Driver Of The Housing Market Despite the broader location flexibility that work-from-home policies now provide to potential homeowners, it seems inconceivable that the housing market would have responded in the manner that it has over the past year given the size of the economic shock brought on by the pandemic without significant support from policy. Above-the-line fiscal measures to the pandemic have totaled in the double-digits in advanced economies (Chart 9), and monetary policy has contributed to easier financial conditions via rate cuts, asset purchases, and sizeable programs to support financial market liquidity. Chart 9There Has Been A Massive Fiscal Policy Response To The Crisis In fact, Charts 10-13 present compelling evidence that fiscal and monetary policy have been the core drivers of significant house price gains over the past year. Charts 10 and 11 plot the above-the-line fiscal response of advanced economies against the year-over-year growth rate in house prices as well as its acceleration (the change in the year-over-year growth rate). The charts show a clearly positive relationship, with a stronger link between the pandemic fiscal response and the acceleration in house prices. Chart 10Differences In Last Year’s Fiscal Response… Chart 11…Help Explain Differences In House Price Gains Chart 12Pre-Pandemic Differences In The Monetary Policy Stance… Chart 13…Do An Even Better Job Of Explaining 2020 House Price Gains   Charts 12 and 13 highlight the even stronger link between house prices and the pre-pandemic monetary policy stance in advanced economies, defined as the difference between each country’s 2-year government bond yield and its Taylor Rule-implied policy interest rate as of Q4 2019. We construct each country’s Taylor Rule using the original specification, with core consumer price inflation, a 2% inflation target, and real potential GDP growth as the definition of the real equilibrium interest rate. The charts make it clear that easy monetary policy strongly explains house price gains in 2020, particularly the year-over-year percent change rather than its acceleration. This makes sense, given that monetary policy was already quite easy in many countries at the onset of the pandemic – meaning that changes were less pronounced than they would have been had interest rates been higher. The explanation that emerges from Charts 10-13 is that historic fiscal easing, combined with an easy starting point for monetary policy – that became even easier last year – enabled demand from work-from-home policies to manifest during an extremely severe recession. We agree that work-from-home policies have shifted the geographic preferences of some home buyers and likely provided a new source of net demand from renters in urban cores purchasing homes in outlying areas. But we strongly doubt that the net effect of work-from-home policies in the midst of an extreme shock to economic activity would have caused the rise in house prices that we have observed, certainly not to this level, without major support from policy. This underscores that policy, and not the work-from-home effect, has and will likely remain the core driver of the global housing market. The Supply Effect: Mostly A Red Herring Chart 14Countries Fall Into Two Groups In Terms Of The Relative Trend In Real Residential Investment One perennial question that emerges when analyzing the housing market, particularly in markets with outsized house price gains, is the impact of constrained supply. It is frequently argued that constrained supply is squeezing prices higher in many markets, and that the appropriate policy solution to extreme house price gains is to enable widespread housing construction – not to raise interest rates. We do not rule out the potential impact of constrained supply in certain cities or regional housing markets, and we have highlighted in previous research that a positive relationship does exist between population density in urban regions and median house price-to-income ratios.1 But as a broad explanation for supercharged house price gains, the supply argument appears to fall flat. Chart 14 presents the most standardized measure of cross-country housing supply available for several advanced economies, the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1), and those that have experienced either an uptrend in housing construction relative to output or have seen a flat trend (panel 2). If scarce housing supply was the core driver of outsized house price gains, then we would expect to see stronger gains in the countries shown in panel 1 and smaller gains in the countries shown in panel 2. In fact, mostly the opposite is true: Charts 15 and 16 highlight that the relationship between the level of these indexes today relative to their 1997 or 2005 levels is positively related to the magnitude of house price gains last year, suggesting that housing market supply has generally been responding to demand over the past decade. The US and possibly New Zealand stand as possible exceptions to the trend, suggesting that relatively scarce supply may be boosting prices even further in these markets beyond what fiscal and monetary policy would suggest. Chart 15Countries That Have Seen A Stronger Pace Of Residential Investment… Chart 16…Have Experienced Stronger House Price Gains   Chart 17Is This Not Enough Supply, Or Too Much Demand? As a final point about the inclination of investors to gravitate towards supply-side arguments related to the housing market, Chart 17 presents a simple thought experiment. The chart shows a simple housing supply-demand curve diagram, in a scenario where the demand curve for housing has shifted out more than the supply curve has (thus raising house prices). Is this a scenario in which supply is too tight? Or is it a case in which demand is too strong? In our view, the tight supply answer is reasonable in circumstances where the increase in demand is normal or otherwise sustainable. But Charts 10-13 clearly showed that housing demand is being boosted by easy policy, which in the case of some countries has occurred for years: interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium, and this has occurred alongside significant household sector leveraging (Chart 18). As such, in our view, investors should be more inclined to view the global housing market as generally being driven by demand-side rather than supply-side factors. This Is Not 2007/08 … Yet We highlighted in Chart 2 above that the household sector debt-to-GDP ratio increased sharply last year, which has raised some questions about debt sustainability among investors. For the most part, the rise in this ratio actually reflects denominator effects (namely a sharp contraction in nominal GDP) rather than a huge surge in household debt. Chart 19 shows BIS data for the annual growth in total household debt in developed economies was roughly stable last year, at least until Q3 (the most recent datapoint available from the BIS). Chart 18Low Interest Rtaes Have Fueled Household Leveraging Chart 19Total Credit Growth Has Been Stable, But Mortgage Credit Growth Is Accelerating Chart 20US Mortgage Growth Is Picking Up, As Repayments Slow Consumer Credit Growth But Chart 19 shows the recent trend in total household debt, which masks diverging mortgage and non-mortgage debt trends. In the US, euro area, Canada, and Sweden, household mortgage debt has accelerated to varying degrees, underscoring that households have likely paid down non-mortgage debt with some of the savings that they have accumulated from a significant reduction in spending on services. Chart 20 shows this effect directly in the case of the US; mortgage debt growth accelerated by roughly 1.5 percentage points in the second half of the year, whereas consumer credit growth (made up of student loans, auto loans, credit cards, and other revolving credit) decelerated significantly. This aligns with data showing that US households have used some of their savings windfall to pay down their credit card balances. This changing mix within household debt - less higher-interest-rate consumer credit, more lower-interest-rate collateralized mortgage debt – could, on the margin, help mitigate financial stability risks from the housing boom by moderating overall debt service burdens. The starting point for the latter matters, though, in accurately assessing the risks from rising house prices and increased mortgage debt, particularly in countries where household debt levels are already high. According to data from the BIS, the US already has one of the lowest household debt service ratios (7.6%) among the developed economies (Chart 21).2 This compares favorably to the double-digit debt service ratios in the “higher-risk” countries like Canada (12.6%), Sweden (12.1%) and Norway (16.2%). On top of that, US commercial banks have become far more prudent with mortgage loan underwriting standards since the 2008 financial crisis. The New York Fed’s Household Debt and Credit report shows that an increasing majority of mortgage lending made by US banks since the 2008 crisis has been to those with very high FICO credit scores (Chart 22). This is in sharp contrast to the steady lending to “subprime” borrowers with poor credit scores that preceded the 2008 financial crisis. The median FICO score for new mortgage originations as of Q1 2021 was 788, compared to 707 in Q4 2006 at the peak of the mid-2000s US housing boom. Chart 21Diverging Trends In Global Household Debt Servicing Costs Chart 22US Banks Have Become More Prudent With Mortgage Lending   US bank balance sheets are also now less directly exposed to a fall in housing values. Residential loans now represent only 10% of the assets on US bank balance sheets, compared to 20% at the peak of the last housing bubble (Chart 23). This puts the US in the “lower-risk” group of countries in Europe, the UK and Japan where mortgages are less than 20% of bank balance sheets. This compares favorably to the “higher risk” group of countries where residential loans are a far larger share of bank assets (Chart 24), like Canada (32%), New Zealand (49%), Sweden (45%) and Australia (40%). Chart 23Banks Have Limited Direct Exposure To Housing Here Chart 24Banks Are Far More Exposed To Housing Here   Like nature, however, the financial ecosystem abhors a vacuum. “Non-bank” mortgage lenders have filled the void from traditional US banks reducing their lending to lower-quality borrowers, and they now represent around two-thirds of all US mortgage origination, a big leap from the 20% origination share in 2007. Non-bank lenders have also taken on growing shares of new mortgage origination in other countries like the UK, Canada and Australia. Chart 25Global Banks Can Withstand A Housing Shock Non-bank lenders do not take deposits and typically fund themselves via shorter-term borrowings, which raises the potential for future instability if credit markets seize up. These lenders also, on average, service mortgages with a higher probability of default, so they are exposed to greater credit losses when house prices decline. However, the risk of a full-blown 2008-style commercial banking crisis, with individual depositors’ funds at risk from a bank failure, are reduced with a greater share of riskier mortgage lending conducted by non-bank entities. This is especially true with global commercial banks far better capitalized today, with double-digit Tier 1 capital ratios (Chart 25), thanks to regulatory changes made after the Global Financial Crisis. Net-net, we conclude that the overall financial stability implications of the current surge in house prices in the developed economies are relatively modest on average. The acceleration in mortgage growth has occurred alongside reductions in non-mortgage growth, at a time when banks are better able to withstand a shock from any sustained future downturn in house prices. However, if house prices continue to accelerate and new homebuyers are forced to take on ever increasing amounts of mortgage debt, financial stability issues could intensify in some countries. Services spending will recover in a vaccinated post-COVID world, as economies reopen and consumer confidence improves, which will likely end the trend of falling non-residential consumer debt offsetting rising mortgage debt in countries like the US and Canada. Overall levels of household debt could begin to rise again relative to incomes, building up future financial stability risks when central banks begin to normalize pandemic-related monetary policies – a process that has already started in some countries because of the housing boom. The Monetary Policy Implications Of Surging House Prices Rapidly appreciating house prices are becoming an area of concern for policymakers in countries like Canada and New Zealand, where the affordability of housing is becoming a political, as well as an economic, issue. In the case of New Zealand, the government has actually altered the remit of the Reserve Bank of New Zealand (RBNZ) to more explicitly factor in the impact of monetary policy on housing costs. The Bank of Canada announced in April that it would taper its pace of government debt purchases and signaled that its decision was based, at least in small part, on signs of speculative behavior in Canada’s housing market. Macroprudential measures like limiting loan-to-value ratios of new mortgage loans are a policy option that governments in those countries have already implemented to try and cool off housing demand. Yet while such measures can help alleviate demand-supply mismatches in certain cities and regions, the efficacy of such measures in sustainably slowing the ascent of house prices on a national scale is unclear. In the April 2021 IMF Global Financial Stability Report, researchers estimated that, for a broad group of countries, the implementation of a new macro-prudential measure designed to cool loan demand reduced national household debt/GDP ratios by a mere one percentage point, on average, over a period encompassing four years.3 If macroprudential measures are that ineffective in sustainably reducing demand for mortgage loans, then the burden of slowing house price appreciation will have to fall on the more blunt instruments of monetary policy. Importantly, surging house price inflation is not likely to give a boost to realized inflation measures – an important issue given the current backdrop of rapidly rising realized inflation rates in many countries. Housing costs do represent a significant portion of consumer price indices in many developed countries, ranging from 19% in New Zealand to 33% in the US (Chart 26), with the euro area being the outlier with housing having a mere 2% weighting in the headline inflation index. Chart 26A Limited Impact On Actual Inflation From Housing Yet those so-called “housing” categories overwhelmingly measure only housing rental costs and not actual house prices. This is an important distinction because rents – which are often imputed measures like in the US and not even actual rental costs - are rising at a far slower pace than actual house prices in most countries, so the housing contribution to realized inflation is relatively modest. So the good news is that booming house prices will not worsen the acceleration of realized global inflation that has concerned investors and policymakers in 2021. Yet that does not mean that central bankers will not be forced to tighten policy to cool off red-hot housing demand that is clearly being fueled by persistently negative real interest rates. In Chart 27 and Chart 28, we show both nominal and real policy interest rates for the “lower risk” and “higher risk” country groupings that we described earlier. The real policy rates are nominal policy rates versus realized headline CPI inflation. The dotted lines in the charts represent the future path of rates discounted by markets. Specifically, the projection for nominal rates is taken from overnight index swap (OIS) forward curves, while the projection for real rates is calculated by subtracting the discounted path of inflation expectations extracted from CPI swap forwards. Chart 27Markets Discounting Negative Real Rates For The Next Decade Chart 28Negative Real Rates Are Unsustainable During A Housing Bubble   There are two key takeaways from these charts: Real policy interest rates are at or very close to the most deeply negative levels seen since the 2008 financial crisis. Markets are discounting that real rates will be at or below 0% for most of the next decade. Admittedly, there is room for debate over what the equilibrium level of real interest rates (a.k.a. “r-star”) should be in the coming years. However, we deem it a major stretch to believe that real rates need to be persistently low or negative for the next ten years to support even trend growth across the developed economies. In our view, the current boom in housing demand and mortgage borrowing provides clear evidence that negative real rates are below equilibrium and, thus, are stimulating credit demand. Thus, the only way for a central bank to cool off housing demand will be to raise both nominal and, more importantly, real interest rates. Canada and New Zealand will be the “canaries in the coal mine” among developed market central banks for such a move. According to the latest Bank of Canada Financial Stability Review, nearly 22% of Canadian mortgages are highly levered, with a loan-to-value ratio greater than 450%, a greater share of such mortgages than during the 2016/17 housing boom (Chart 29). Canadian house prices have risen to such an extent that home prices in major cities like Toronto, Vancouver and Montreal are among the most expensive in North America.4  Stunningly, a recent Bloomberg Nanos opinion poll revealed that nearly 50% of Canadians would support Bank of Canada rate hikes to cool off the red-hot housing market (Chart 30). The central bank will be unable to resist the pressure to use monetary policy to slam on the brakes of the housing market – investors should expect more tapering and, eventually, rate hikes from the Bank of Canada over at least the next couple of years. Chart 29Canadians Are Leveraging Up To Buy Expensive Homes Chart 3050% Of Canadians Want A Rate Hike To Cool Housing   In New Zealand, worsening housing affordability has reached a point where a 20% down payment on the median national house price is equal to 223% of median disposable income (Chart 31). This is forcing more first-time home buyers to take on levels of mortgage debt that the RBNZ deems highly risky (top panel). Like the Bank of Canada, the RBNZ will prove to be one of the most hawkish central banks in the developed world over the next couple of years as the central bank follows their newly-revised remit to try and cool off housing demand in New Zealand. Who is next? Housing values, measured by the ratio of median national house prices to median national household incomes, are rising in the US and UK but are still below the peaks of the mid-2000s housing bubble (Chart 32). Meanwhile, housing is becoming more expensive across the euro area, but not in a consistent manner, with valuations in Germany and Spain having increased far more than in France or Italy. Housing valuations have actually improved in Australia over the past couple of years on a price-to-income basis. The most likely candidates for a housing-related hawkish turn are in Scandinavia, with housing valuations in Sweden and Norway closing in on Canada/New Zealand levels. Chart 31New Zealand Housing Is Wildly Unaffordable Chart 32Global House Price/Income Ratios Are Trending Higher   Investment Conclusions The current acceleration in global house prices is an inevitable outcome of the extraordinary monetary and fiscal easing implemented during the pandemic. Higher realized inflation is pushing real rates deeper into negative territory in many countries, fueling the demand for housing. Central banks in countries with more stretched housing valuations will be forced to turn more hawkish sooner than expected, leading to tapering and, eventually, rate hikes to cool housing demand. This has negative implications for government bond markets in countries where housing is more expensive and real yields remain too low, like Canada, New Zealand and Sweden (Chart 33). Investors should limit exposure to government bonds in those markets over the next 6-12 months. Chart 33Negative Real Yields & Expensive Housing Valuations – An Unsustainable Mix Bond markets in countries where house prices are not rising rapidly enough to force policymakers to turn more hawkish more quickly – like core Europe, Australia and even Japan - are likely to be relative outperformers. The US and UK are “cuspy” bond markets, as housing valuations are becoming more expensive in those two countries but the Fed and Bank of England are not facing the same domestic political pressure to use monetary policy tools to fight the growing unaffordability of housing. That could change, though, if overall household leverage begins to rise alongside house price inflation as the US and UK economies emerge from the pandemic. Current pricing in OIS curves shows that markets expect the RBNZ and Bank of Canada to begin hiking rates in May 2022 and September 2022, respectively (Table 1). This is well ahead of expectations for “liftoff” from other developed markets central banks, including the Fed in April 2023. The cumulative amount of rate hikes following liftoff to the end of 2024 is highest in Canada, New Zealand, the US and Australia. Those are also countries with currencies that are trading at or above the purchasing power parity levels derived from our currency strategists’ valuation models. This highlights the difficult choice that central bankers facing housing bubbles must confront, as the rate hikes that will help cool off housing demand will lead to currency appreciation that could impact other parts of their economies like exports and manufacturing. Table 1Hawkish Central Banks Must Live With Currency Strength Tracking the second-round economic consequences of eventual monetary policy actions to control excessive house price inflation, particularly in “higher risk” countries, is likely to be the subject of future Bank Credit Analyst / Global Fixed Income Strategy reports. Robert Robis, CFA Chief Fixed Income Strategist Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com 2 Importantly, the BIS debt service ratios include the payment of both principal and interest, thus making it a true measure of debt service costs that includes repayment of borrowed funds – a critical issue in countries with high loan-to-value ratios for home mortgages. 3 Please see page 46 of Chapter 2 of the April 2021 IMF Global Financial Stability Report, which can be found here: https://www.imf.org/en/Publications/GFSR/Issues/2021/04/06/global-financial-stability-report-april-2021 4 “Vancouver, Toronto and Hamilton are the least affordable cities in North America: report”, CBC News, May 20, 2021

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

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