Currencies

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Chart 2Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Chart 6Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 Chart 12Gas Production Is Rising In Importance Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I Chart 23The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency Chart 26NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Political and corporate climate activism will increase the cost of developing the resources required to produce and deliver energy going forward – e.g., oil and gas wells; pipelines; copper mines, and refineries. Over the short run, the fastest way for investor-owned companies (IOCs) to address accelerated reductions in CO2 emissions imposed by courts and boards is to walk away from the assets producing them, which could be disruptive over the medium term. Longer term, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources needed to produce and distribute energy. The real difficulty will come in the medium term. Capex for critical metals like copper languishes, just as the call on these metals steadily increases over the next 30 years (Chart of the Week). The evolution to a low-carbon future has not been thought through at the global policy level. A real strategy must address underinvestment in base metals and incentivize the development of technology via a carbon tax – not emissions trading schemes – so firms can innovate to avoid it. We remain long energy and metals exposures.1 Feature And you may ask yourself, "Well … how did I get here?" David Byrne, Once In A Lifetime Energy markets – broadly defined – are radically transforming from week to week. The latest iteration of these markets' evolution is catalyzed by climate activists, who are finding increasing success in court and on corporate boards – sometimes backed by major institutional investors – and forcing oil and gas producers to accelerate CO2 emission-reduction programs.2 Climate activists' arguments are finding increasing purchase because they have merit: Years of stiff-arming investors seeking clarity on the oil and gas producers' decarbonization agendas, coupled with a pronounced failure to provide returns in excess of their cost of capital, have given activists all of the ammo needed to argue their points. Chart of the WeekCall On Metals For Energy Will Increase This activism is not limited to the courts or boardrooms. Voters in democratic societies with contested elections also are seeking redress for failures of their governments to effectively channel mineral wealth back into society on an equitable basis, and to protect their environments and the habitats of indigenous populations. This voter activism is especially apparent in Chile and Peru, where elections and constitutional conventions likely will result in higher taxes and royalties on metals IOCs operating in these states, which will increase production costs and ultimately be passed on to consumers.3 These states account for ~ 40% of world copper output. IOCs Walk Away Earlier this week, Exxon walked away from an early-stage offshore oil development project in Ghana.4 This followed the unfavorable court rulings and boardroom setbacks experienced by Royal Dutch Shell, Chevron and Exxon recently (referenced in fn. 2). While the company had no comment on its abrupt departure, its action shows how IOCs can exercise their option to put a project back to its host government, thus illustrating one of the most readily available alternatives for energy IOCs to meet court- or board-mandated CO2 emissions targets. If these investments qualify as write-offs, the burden will be borne by taxpayers. As climate activism increases, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources – particularly oil and gas – needed to produce and distribute energy going forward. This is not an unalloyed benefit, as the SOCs still face stranded-asset risks, if they invest in longer-lived assets that are obviated by a successful renewables + grid buildout globally. That is a cost that will have to be compensated, when the SOCs work up their capex allocations. Still, if legal and investor activism significantly accelerates IOCs' capex reductions in oil and gas projects, the SOCs – particularly those in OPEC 2.0 – will be able to expand their position as the dominant supplier in the global oil market, and could perhaps increase their influence on price levels and forward-curve dynamics (Chart 2).5 Chart 2OPEC 2.0s Could Expand If Investor Activism Increases Higher Call On Metals At present, there is a lot of talk about the need to invest in renewable electricity generation and the grid structure supporting it, but very little in the way of planning for this transition. Other than repeated assertions of its necessity, little is being said regarding how exactly this strategy will be executed given the magnitude of the supply increase in metals required. Nowhere is this more apparent than in the refined copper market, which has been in a physical deficit – i.e., production minus consumption is negative – for the last 6 years (Chart 3). Physical copper markets in China, which consumes more than 50% of refined output, remain extremely tight, as can be seen in the ongoing weakness of treating charges and refining charges (TC/RC) for the past year (Chart 4). These charges are inversely correlated to prices – when TC/RCs are low, it means there is surplus refining capacity for copper – unrefined metal is scarce, which drives down demand for these services. Chart 3Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains TightTheoretically, high prices will incentivize higher levels of production. However, after the last decade’s ill-timed investment in new mine discoveries and expansions, mining companies have become more wary with their investments, and are using earnings to pay dividends and reduce debt. This leads us to believe that mining companies will not invest in new mine discoveries but will use capital expenditure to expand brownfield projects to meet rising demand. In the last decade, as copper demand rose, capex for copper rose from 2010-2012, and fell from 2013-2016 (Chart 5). During this time, the copper ore grade was on a declining trend. This implies that the new copper brought online was being mined from lower-grade ore, due to the expansion of existing projects(Chart 6). Chart 5Copper Capex Growth Remains Weak Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle Capex directed at keeping ore production above consumption will not be sufficient to avoid major depletions of ore supplies beginning in 2024, according to Wood Mackenzie. The consultancy foresees a cumulative deficit of ~ 16mm MT by 2040. Plugging this gap will require $325-$500 billion of investment in the copper mining sector.6 The Case For A Carbon Tax The low-carbon future remains something of a will-o'-the-wisp – seen off in the future but not really developed in the present. Most striking in discussions of the low-carbon transition is the assumption of resource availability – particularly bases metals –in, e.g., the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector, published last month. In the IEA's document, further investment in hydrocarbons is not required beyond 2025. The copper, aluminum, steel, etc., required to build the generation and supporting grid infrastructure will be available and callable as needed to build all the renewable generation the world requires. The document is agnostic between carbon trading and carbon taxes as a way to price carbon and incentivize the technology that would allow firms and households to avoid a direct cost on carbon. A real strategy must address the fact that most of the world will continue to rely on fossil fuels for decades, as development goals are pursued. Underinvestment in base metals and its implications for the buildout of generation and grids has to be a priority if these assets are to be built. Given the 5-10-year lead times base metals mines require to come online, it is obvious that beyond the middle of this decade, the physical reality of demand exceeding supply will assert itself. A good start would be a global effort to impose and collect carbon taxes uniformly across states.7 This would need to be augmented with a carbon club, which restricts admission and trading privileges  to those states adopting such a scheme. Harmonizing the multiple emissions trading schemes worldwide will be a decades-long effort that is unlikely to succeed. Such schemes also can be gamed by larger players, producing pricing distortions. A hard and fast tax that is enforced in all of the members of such a carbon club would immediately focus attention on the technology required to avoid paying it – mobilizing capital, innovation and entrepreneurial drive to make it a reality. This would support carbon-capture, use and storage technologies as well, thus extending the life of existing energy resources as the next generation of metals-based resources is built out. In addition, a carbon tax raises revenue for governments, which can be used for a variety of public policies, including reducing other taxes to reduce the overall burden of taxation. Lastly, a tax eliminates the potential for short-term price volatility in the pricing of carbon – as long as households and firms know what confronts them they can plan around it.  Tax revenues also can be used to reduce the regressive nature of such levies. Investment Implications The lack of a coherent policy framework that addresses the very real constraints on the transition to a low-carbon economy makes the likelihood of a volatile, years-long evolution foreordained. We believe this will create numerous investment opportunities as underinvestment in hydrocarbons and base metals production predisposes oil, natural gas and base metals prices to move higher in the face of strong and rising demand. We remain long commodity index exposure – the S&P GSCI and GSCI Commodity Dynamic Roll Strategy ETF (COMT), which is optimized to take advantage of the most backwardated commodity forward curves in the index. These positions were up 5.3% and 7.2% since inception on December 7, 2017 and March 12, 2021, respectively, at Tuesday's close. We also remain long the MSCI Global Metals & Mining Producers ETF (PICK), which is up 33.9% since it was put on December 10, 2020. Expecting continued volatility in metals – copper in particular – we will look for opportunities to re-establish positions in COMEX/CME Copper after being stopped out with gains. A trailing stop was elected on our long Dec21 copper position established September 10, 2020, which was closed out with a 48.2% gain on May 21, 2021. Our long calendar 2022 vs short calendar 2023 COMEX copper backwardation trade established April 22, 2021, was closed out on May 20, 2021, leaving us with a return of 305%.   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 OPEC 2.0 offered no surprises to markets this week, as it remained committed to returning just over 2mm b/d of production to the market over the May-July period, 70% of which comes from the Kingdom of Saudi Arabia (KSA), according to Platts. While Iran's return to the market is not a given in OPEC 2.0's geometry, we have given better than even odds it will return to the market beginning in 3Q21 and restore most of the 1.4mm b/d not being produced at present to the market over the course of the following year. OPEC itself expects demand to increase 6mm b/d this year, somewhat above our expectation of 5.3mm b/d. Stronger demand could raise Brent prices above our average $63/bbl forecast for this year (Chart 7). Brent was trading above $71/bbl as we went to press. Base Metals: Bullish BHP declared operations at its Escondida and Spence mines were running at normal rates despite a strike by some 200 operations specialists. BHP is employing so-called substitute workers to conduct operation, according to reuters.com, which also reported separate unions at both mines are considering strike actions in the near future. Precious Metals: Bullish The Fed’s reluctance to increase nominal interest rates despite indications of higher inflation will reduce real rates, which will support higher gold prices (Chart 8). We agree with our colleagues at BCA Research's US Bond Strategy that the Fed is waiting for the US labor market to reach levels consistent with its assessment of maximum employment before it makes its initial rate hike in this interest-rate cycle. Subsequent rate changes, however, will be based on realized inflation and inflation expectations. In our opinion, the Fed is following this ultra-accommodative monetary policy approach to break the US liquidity trap, brought about by a rise in precautionary savings due to the pandemic. In addition, we continue to expect USD weakness, which also will support gold and precious metals prices. We remain long gold, expecting prices to clear $2,000/oz this year. Ags/Softs: Neutral Corn prices fell more than 2% Wednesday, following the release of USDA estimates showing 95% of the corn crop was planted by 31 May 2021, well over the 87% five-year average. This was in line with expectations. However, the Department's assessment that 76% of the crop was in good-to-excellent condition exceeded market expectations. Chart 7 Chart 8 Footnotes 1     Please see Trade Tables below. 2     Please see OPEC, Russia seen gaining more power with Shell Dutch ruling and EXCLUSIVE BlackRock backs 3 dissidents to shake up Exxon board -sources published by reuters.com June 1, 2021 and May 25, 2021. 3    Please see Chile's govt in shock loss as voters pick independents to draft constitution published by reuters.com May 17, 2021, and Peru’s elite in panic at prospect of hard-left victory in presidential election published by ft.com June 1, 2021.  Peru has seen significant capital flight on the back of these fears.  See also Results from Chile’s May 2021 elections published by IHS Markit May 21, 2021 re a higher likelihood of tax increases for the mining sector.  The risk of nationalization is de minimis, according to IHS. 4    Please see Exxon walks away from stake in deepwater Ghana block published by worldoil.com June 1, 2021. 5    Please see OPEC 2.0's Production Strategy In Focus, which we published on May 20, 2021, for a recap our how we model OPEC 2.0's strategy.  It is available at ces.bcaresearch.com. 6    Please see Will a lack of supply growth come back to bite the copper industry?, published by Wood Mackenzie on March 23, 2021. 7     Please see The Challenges and Prospects for Carbon Pricing in Europe published by the Oxford Institute for Energy Studies last month for a discussion of carbon taxes vs. emissions trading schemes.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

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

Highlights Our long-term FX REER models suggest the dollar remains overvalued, especially against the Chinese yuan.  The cheapest currencies are the yen and the Russian ruble. The Scandinavian currencies are surprisingly expensive, according to these models. This has been due to falling relative productivity. Other notable expensive currencies are the Hong Kong dollar and Saudi riyal. That said, we do not expect the peg in the former to break anytime soon. Our limit-sell on the yen was triggered at 109. Place stops at 112. We are looking to buy a basket of petrocurrencies that include the COP and RUB. These have significantly lagged the rise in oil prices.  Feature This week’s report focuses on our long-term fair value models. But a few words first on currency developments. In our view, currency markets are likely to remain driven by five important trends in the coming months. A rotation of growth from the US to other parts of the world (dollar bearish): This has been the dominant theme that has played out since the peak in the DXY index in March. The manufacturing sector in other countries first caught up to the buoyancy we saw in the US, and their service sectors are now recovering as the world vaccinates its population and reopens. In the developed world, Japan, which has been a laggard, could witness a bout of positive surprises. Market focus on inflation, and the potential of an overshoot (dollar bearish): Most market participants have been paying close attention to the inflation overshoot in the US, and whether it is transitory. Currency markets however, specifically the dollar, have been paying close attention to the inflation differential between the US and other countries, and what that means for relative real rates. A rising inflation differential between the US and its trading partners has been negative for the dollar (Chart I-1). We have noted that the US will continue to provide relative upside surprises in inflation as the US output gap closes ahead of other countries. This has been in part due to the most generous fiscal stimulus in the developed world. Chart I-1The Dollar And Relative Inflation Move Opposite Ways A Federal Reserve that stays ultra-accommodative (dollar bearish): Most market participants are again focused on the Fed tapering and what that will mean for asset markets. The reality is that the Fed has started to lag many other central banks, like the Bank of Canada, the Reserve Bank of New Zealand and the Bank of England in tapering asset purchases. This could suggest it would also lag in the speed and magnitude of lifting policy rates in the medium term. This will keep US real rates depressed relative to many of its trading partners. A risk event (dollar bullish): We have been highlighting that a risk event, like a market reset, is a strong positive for the dollar, given the negative correlation with risk assets (Chart I-2). A dollar that remains expensive (dollar bearish): Our medium-term (12-18 month) target for the DXY index is 80. This will bring the currency towards fair value, according to our purchasing power parity models. As we highlighted last week, the trade balance in the US continues to deteriorate, which is one of the symptoms of an overvalued currency. Chart I-2The Dollar And Risk Assets Move Opposite Ways Despite our bearish dollar view, it is important not to overstay our welcome. This week, we are updating our long-term models, another technical tool we use to help us navigate FX markets. These models are mostly driven by relative productivity, but we have also fine-tuned the models for each currency to account for other factors such as terms-of-trade shocks, real rate differentials and proxies for global risk aversion. These models cover 22 currencies, incorporating both G10 and emerging FX markets. The dollar remains expensive according to these models (Chart I-3). Chart I-3The US Dollar Remains Expensive It is important to note that these models are very poor timing tools and are not designed to generate short- or medium-term forecasts. Instead, they reflect imbalances in the current equilibrium fair value of a currency. For example, a currency might be flagged as overvalued now, but a productivity boom in the next few years could allow the currency fair value to gravitate higher. So will a commodity boom. From a technical perspective, these models are like the ones we published in our last report, but with a very important change – the weights assigned in calculating relative productivity are based on dynamic trade weights. This has allowed China (which has much better productivity growth) to impact the currency fair values significantly. For all countries, the variables are highly statistically significant and are of the right signs. Finally, as housekeeping, we were triggered into a short USD/JPY position this week as our limit-sell at 109 was touched. The yen is one of the cheapest currencies according to these models. It will also benefit from all of the five key drivers for currency markets we listed above, especially real rates that are likely to stay very favorable in Japan, compared to the US (Chart I-4). Chart I-4Less Inflationary Pressures In Any Japanese Economic Rebound The US Dollar Chart I-5 The dollar is expensive by 7% according to the long-term fair value model. This is despite the 13% drop in the US dollar DXY index since the March 2020 highs. In hindsight, strong reversals in the dollar occur when the currency is about two-standard deviations above the mean, which occurred with last year’s rally. Our bias is that the dollar has entered a multi-year downtrend, which will only be supercharged by expensive valuations. The big driver for the uptrend that started in 2011 was positive real interest rate differentials. As US real rates continue to rollover, relative to its G10 counterparts, this will lower the greenback’s fair value. The Euro Chart I-6 The euro is slightly cheap according to our fundamental models. More importantly, the euro’s fair value has been rising in recent quarters. This has been driven by a nascent improvement in the trade balance (and current account balance), following the Covid-19 crisis. Historically, when the euro has hit its fair value bands, it has tended to mean revert. Therefore, this model does a better job of catching intermediate turns in the euro, compared to the US dollar model. Our bias is that the long-term fair value for the euro sits near 1.35, something that should continue to be reflected in future model updates. The Yen Chart I-7 The fair value of the yen has been relatively flat over the last few years. Given that the real exchange rate has not fluctuated much either, the yen has been chronically undervalued by about one standard deviation below the mean. The yen is cheap by most measures of relative prices. We believe the yen sits at a beautiful juncture. A pickup in economic activity will keep the fair value rising, from an improvement in the current account. Meanwhile, any deterioration in economic data will lead to higher risk aversion and a higher fair value (the yen is a risk-off currency). We are short USD/JPY as of 109 this week.   The British Pound Chart I-8 This model shows that the pound is fairly valued, while cable remains cheap by most of our other models. That said, at fair value, the pound can still overshoot to at least 1.5 standard deviation above/below the mean, as it has in prior episodes. The key reason the pound is not cheap in this model is due to a deterioration in the UK’s productivity growth, relative to its trading partners. In this iteration of the model, China’s larger share of British trade has exacerbated the downtrend in the fair value. However, a turnaround seems underway, as the UK puts the Brexit woes behind it (and Scottish independence is not an immediate concern). The Canadian Dollar Chart I-9 The loonie has overshot its fair value. More importantly, the fair value for the Canadian dollar has been falling since the peak of the commodity cycle in 2011. If we are indeed entering a new commodity super-cycle, then the model should begin to turn around, and assign a higher fair value to the loonie. However, Canada’s terms of trade will face strong headwinds as we move away from fossil fuels, especially oil. As such, the productivity gains in other sectors (such as metals) that will benefit from new green investments will need to be sufficiently high to offset falling productivity in crude oil.  The Australian Dollar Chart I-10 The Australian dollar has been rising along with the improvement in its fair value. The rising fair value has been due to the exceptional rise in commodity prices (iron ore and coal) that have boosted the current account. However, like the Canadian dollar, the fair value of the Aussie has also been dropping in recent years on the back of previously depressed commodity prices. Given the growing importance of liquified natural gas in Australia’s export mix, we believe terms of trade will remain a tailwind for the Aussie over the longer term. The New Zealand Dollar Chart I-11 The kiwi is slightly more expensive than its antipodean neighbor. But like other commodity currencies, its fair value has fallen in recent years. The catalyst has been the drop in commodity prices and the fall in relative real rates. More recently, the fair value of the kiwi has taken a positive turn as real rates improve, and risk aversion recedes. With the RBNZ striking a hawkish tone, this remains positive for the kiwi for now, but could adversely impact financial conditions later. The Swiss Franc Chart I-12 On a fundamental basis, the Swiss franc is as cheap as the yen, with our models showing it as about one standard deviation undervalued. The biggest driver for the rise in the fair value of the franc has been the structural trade surplus, driven by rising productivity. The Swiss franc is traditionally a defensive currency. As such, the fair value has taken a small hit due to the fall in the gold-to-oil ratio, a proxy for risk aversion. Should the market experience some turbulence in the coming months, the franc will benefit. The Swedish Krona Chart I-13 The Swedish krona is showing up as expensive in our models, together with the Norwegian krone. Paradoxically, on a PPP basis, the Swedish krona is one of the cheapest currencies in our universe. The key model inputs for the Swedish krona are interest rate differentials and relative productivity trends. With the rise of China as a trading partner, the productivity differential for Sweden has fallen even more steeply in this iteration of the model. It also means that the currency is no longer massively undershooting fair value, as had been the case in previous iterations. The Norwegian Krone Chart I-14 Like the Swedish krona, the Norwegian krone is showing up as expensive in our models. However, it is one of the cheapest currencies on a PPP basis, which presents a paradox. We will be looking at the Norwegian economy in-depth next week, to help explain this paradox. A more immediate explanation is that the trade balance for Norway has been nosediving in recent years, which helps explain why the model judges the currency as becoming incrementally expensive. With the rise of China as a trading partner, the productivity differential for Norway has also fallen. The Chinese Yuan Chart I-15 The Chinese yuan is currently at about one standard deviation below fair value. Since the history of our model, the fair value of the yuan has been mostly rising. This is driven by rising relative productivity in China. Concurrently, real interest rates in China have also shot up, which has led to a strong rally in the Chinese RMB. We expect the RMB to keep appreciating in the coming years, as the fair value keeps rising.  The Brazilian Real Chart I-16 The Brazilian real is slightly above fair value, according to our fundamental models. Meanwhile, the fair value has been falling since 2011, in line with other commodity currencies. However, if we are indeed in a new commodity super cycle, the fair value of the real should start to rise. The Mexican Peso Chart I-17 The Mexican Peso is trading a nudge above fair value, but the fair value has been rising since 2019. This means going forward, we could see a rising peso, coinciding with a rapid rise in its fair value. The peso is highly cyclical, so two key drivers have been working in favor of the currency. First, a falling in risk aversion (proxied by a decline in the gold-to-oil ratio) has been positive. Meanwhile, the cumulative current account will also continue to improve should global growth remain strong in the near term, especially US growth. The Chilean Peso Chart I-18 The Chilean peso is currently at fair value, according to our fair value model. The fair value of the Chilean peso has been falling in recent years, but this decline was even sharper when Chinese productivity gains were given a greater weight in the modelling exercise. Going forward, Chilean exports of copper will be in a structural uptrend, due to the green technology revolution. As such, the fair value of the peso should begin to gradually rise. The Colombian Peso Chart I-19 The Colombian peso is cheap, and so constitutes an attractive play if oil prices remain strong in the medium term. The reason is that it has one of the strongest correlations to oil prices among commodity currencies. That said, structurally, the fair value of the Colombian peso has been falling, like many other petrocurrencies. The South African Rand Chart I-20 The South African rand is now trading slightly below its fair value, a positive contrast to the BRL which is slightly expensive. Meanwhile, the fair value of the rand is gradually picking up, after a structural decline over the last decade.   The correlation between precious metal prices and the South African rand is picking up again, as the current account moves back into surplus. We are positive gold (and silver) as inflation hedges. Meanwhile, platinum and palladium will continue to benefit from a push towards better environmental standards among traditional autos. The Russian Ruble Chart I-21 The Russian ruble is now sitting around one standard deviation below its fair value. We are constructive on oil, which will boost the fair value of petrocurrencies, including the Russian ruble. Meanwhile, real interest rates are at relatively high levels in Russia, even though this does not have significant explanatory power. Given cheap valuations, we are looking to buy a petrocurrency basket, including the RUB and the COP. The Korean Won Chart I-22 The Korean won has underperformed this year, and has been trading at a negligible divergence from its fair value over the last few years. The fair value of the Korean won has also been flat over the years. This suggests that Korean productivity growth has kept pace with its trading partners. Going forward, it also suggests the next move in the Korean won is likely to be driven by the trend in the currencies of its trading partners, especially China and the US. The Philippine Peso Chart I-23 The Philippine peso is expensive by about one standard deviation. This has been partly due to a decline in the fair value of the peso, a process that began in 2015.  The Philippine peso is one of the few currencies whose REER tends to have well-defined and long cycles that last 5-8 years. It will be important to watch if the recent appreciation in the currency has more room to run, given expensive valuation. The Singapore Dollar Chart I-24 The Singaporean dollar is another currency whose REER tends to have long cycles, probably a feature of the managed float. The Singaporean dollar is a defensive currency, and so the appreciation in other emerging market currencies has brought relative valuations back towards fair value. The Hong Kong Dollar Chart I-25 The REER of HKD has been rising in recent years, meaning inflation in Hong Kong SAR has been outpacing that elsewhere. This has made the HKD expensive, according to our models. However, the fair value has started to fall suggesting productivity gains in the city state have also been lagging, probably a result of political unrest. That said, we expect the peg to remain in place for some time, as we highlighted in a previous special report. The Saudi Riyal Chart I-26 The fair value of the Saudi Riyal has been falling for quite a while on declining relative productivity. This has made the Riyal incrementally expensive. However, oil prices are currently elevated, which means it might take much more stretched valuations to begin to cause greater tensions for the peg.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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