Currencies

Highlights The US dollar will reach its ultimate high in the next deflationary shock. The swing factor for dollar demand is portfolio flows. In the next shock, portfolio flows will surge into US investments, driving up the US dollar to its ultimate high. One reason is that the US T-bond is the only major bond that can act as a haven-asset, now that most other bond yields are close to the effective lower bound. For US investors, international stocks will create a double-jeopardy. Not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. For non-US investors, the US 30-year T-bond will create a double-win from price surge and dollar surge, leading to a potential doubling of your money. Fractal trade shortlist: stocks versus bonds, tin, and US REITS versus US utilities. Feature Chart of the WeekSuccessive Shocks Take The Dollar To New Highs Successive Shocks Take The Dollar To New Highs Successive Shocks Take The Dollar To New Highs In our recent report The Shock Theory Of Bond Yields we explained that the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that an economy has endured. Each successive deflationary shock takes the bond yield to a lower low. Until it can go no lower (Chart 2). Chart I-2Successive Shocks Take The T-Bond Yield To New Lows Successive Shocks Take The T-Bond Yield To New Lows Successive Shocks Take The T-Bond Yield To New Lows Today’s report explains an important corollary. Each major deflationary shock has taken the US dollar to a new high, led by strong rallies against cyclical currencies such as the pound and the Canadian dollar (Chart of the Week, Chart I-3 and Chart I-4). We conclude that the US dollar will reach its ultimate high in the next deflationary shock. Chart I-3USD/GBP Surges In Shocks USD/GBP Surges In Shocks USD/GBP Surges In Shocks Chart I-4USD/CAD Surges In Shocks USD/CAD Surges In Shocks USD/CAD Surges In Shocks   Investors Must Build Shocks Into Their Strategy Most strategists claim that shocks, such as the pandemic, are inherently unpredictable. They argue that shocks are exogenous events that investors cannot plan for. We disagree. Granted, the timing and source of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the likelihood of suffering a shock is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or to slump by at least 25 percent.1 Using this definition through the past five decades, shocks have arrived with a remarkable predictability (Chart I-5). As a statistical distribution, the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). Chart I-5A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years Hence, in any three-year period, the likelihood of suffering a shock is 50 percent; in a five-year period, it is 81 percent; and in a ten-year period, it is a near-certain 96 percent (Chart I-6). Chart I-6On A Multi-Year Horizon, A Shock Is A Near-Certainty Why The Dollar’s Ultimate High Is Yet To Come Why The Dollar’s Ultimate High Is Yet To Come Yet, to repeat, the precise source and timing of the near-certain shock is unknown. This creates a dissonance for our narrative-focused minds. Absent a narrative for the certain shock, we do not plan for it. But we should. For long-term investors one crucial takeaway is that the ultimate low in the T-bond yield is yet to come. Another crucial takeaway is that the ultimate high in the US dollar is also yet to come. In A Shock, The US Dollar Surges The net demand for dollars comes from four sources: To fund the demand for goods and services denominated in dollars. (In fact, the structural US deficit in goods and services means that this source generates a persistent supply of dollars.) To fund the demand for long-term investments denominated in dollars, also known as foreign direct investment (FDI). To fund the demand for shorter-term financial investments like bonds and equities denominated in dollars, also known as portfolio flows.2 To fund the demand for currency reserves denominated in dollars. Of these four sources of dollar demand, the US deficit in goods and services is not particularly volatile. FDI flows also change relatively slowly. Meanwhile, demand for dollar reserves is a residual factor, except at the rare moment that a currency peg starts or ends.3  The largest quarterly swings in portfolio flows swamp the largest quarterly swings in the trade balance and FDI. This means that the swing factor for dollar demand is portfolio flows. Chart I-7 and Chart I-8 show that the largest quarterly swings in portfolio flows, at over $1.5 trillion (annualised rate) swamp the largest quarterly swings in the trade balance and FDI, at just $0.5 trillion. Chart I-7The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows Chart I-8The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows The Swing Factor For Dollar Demand Is Portfolio Flows All of which brings us to the main point of this report. In a shock, portfolio flows surge into US investments, which drives up the US dollar. In a shock, portfolio flows surge into US investments, which drives up the US dollar. There are two reasons for this. First, the US stock market is one of the most defensive in the world. Hence, in a shock, equity flows flood into the US (Chart I-9). Chart I-9The US Stock Market Is One Of The Most Defensive In The World The US Stock Market Is One Of The Most Defensive In The World The US Stock Market Is One Of The Most Defensive In The World But even more important now, the US T-bond is the only major bond that can act as a haven-asset. With most other bond yields already close to the effective lower bound, the US T-bond is the only mainstream asset which still has substantial scope to rally when other asset prices are collapsing. Hence, in recent years, the dollar is just tracking the performance of bonds versus stocks (Chart I-10). It follows that in the next deflationary shock, when bonds surge versus stocks, the dollar will surge to its ultimate high. Chart I-10The Dollar Is Just Tracking Bonds Versus Stocks The Dollar Is Just Tracking Bonds Versus Stocks The Dollar Is Just Tracking Bonds Versus Stocks An Inflationary Shock Will Quickly Morph Into A Deflationary Shock But what if the next shock is a dollar crisis? Such a crisis, caused by a loss of faith in the greenback as a store of value, would start off inflationary – to the detriment of the dollar. However, our high-conviction view is that even if the shock started as inflationary, it would quickly morph into deflationary. The simple reason is that the initial backup in bond yields that would come from such an inflationary shock would collapse the value of $500 trillion worth of global real estate, equities, and other risk-assets, and thereby unleash a massive deflationary impulse. Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. Investors demand a massive risk premium when inflation is out of control. The starting valuation needed to generate a given real return during an inflationary shock collapses because investors demand a massive risk premium when inflation is out of control. For example, in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But to generate the same real return of 10 percent during the inflationary 1970s, the starting multiple had to halve to 7 (Chart I-11). Chart I-11In An Inflationary Shock, Valuations Collapse In An Inflationary Shock, Valuations Collapse In An Inflationary Shock, Valuations Collapse Suffice to say, if the valuation of $500 trillion of global risk-assets were to halve, we would not have to worry about inflation. So, to sum up: On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise source or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a net deflationary shock or shocks into their long-term investment strategy. Specifically, in the next shock: US equities will outperform non-US equities. The 10-year T-bond yield will reach zero, and the 30-year T-bond yield will reach 0.5 percent. The US dollar will reach its ultimate high. This leads to two very important messages, one for US investors, one for non-US investors. For US investors, international stocks will create a double-jeopardy. In the next shock, not only will non-US stocks underperform US stocks, but non-US currencies will underperform the dollar. The corollary for non-US investors is that the US 30-year T-bond will create a double-win. Not only will the T-bond price surge, but the dollar will also reach a new high. The combination will lead to a potential doubling of your money. H1 2021 Win Ratio Reaches A Magnificent 71 Percent Last Thursday’s 16 percent rally in Nike shares on a brighter sales outlook means that our long Nike versus L’Oréal trade quickly achieved its 9 percent profit target. Long USD/HUF also quickly achieved its 3 percent profit target. Combined with other ‘wins’, this has boosted the fractal trades win ratio for H1 2021 to a magnificent 71 percent – comprising 12.1 wins versus just 4.9 losses. A fragile fractal structure is a warning that the investors setting the investment’s price has become dangerously biased to short-term traders. As longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. This creates an excellent countertrend investment opportunity because once the longer-term investors re-enter the price setting process, the recent trend will reverse. This week we highlight three fragile fractal structures. The fractal structure of stocks versus bonds (MSCI All Country World versus 30-year T-bond) remains fragile, suggesting that a neutral stance, at best, for stocks versus bonds through the summer (Chart I-12). Chart I-12The Fractal Structure Of Stocks Versus Bonds Is Fragile The Fractal Structure Of Stocks Versus Bonds Is Fragile The Fractal Structure Of Stocks Versus Bonds Is Fragile The fractal structure of tin is also fragile (Chart I-13). Given that most commodity prices have begun corrections, tin is vulnerable – especially versus other commodities. Chart I-13The Fractal Structure Of Tin Is Fragile The Fractal Structure Of Tin Is Fragile The Fractal Structure Of Tin Is Fragile Finally, comparing two high-yielding sectors, the fractal structure of US REITS versus US utilities is at a point of fragility that has reliably presaged countertrend moves (Chart I-14). Accordingly, this week’s recommended trade is to short US REITS versus US utilities, setting the profit target and symmetrical stop-loss at 5 percent. Chart I-14Short US REITS Versus US Utilities Short US REITS Versus US Utilities Short US REITS Versus US Utilities   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 In this discussion, portfolio flows include short-term speculative flows. 3For example, if a currency broke its peg with the dollar it would stop buying the dollar reserves needed to maintain the peg. 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 II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart I-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart I-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart I-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart I-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, July 8 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic Outlook: Global growth is peaking but will remain solidly above trend. While the proliferation of the Delta strain is likely to trigger another wave of Covid cases this summer, the economic impact will be far smaller than during past waves. Global Asset Allocation: The risk-reward profile for stocks has deteriorated since the start of the year. Nevertheless, with few signs that the global economy is heading towards another major downturn, investors should maintain a modest equity overweight on a 12-month horizon. Equities: Favor cyclicals, value-oriented, and non-US equities. Emerging markets should spring back to life in the autumn once vaccine supplies increase and Chinese fiscal policy turns more stimulative. Fixed Income: Maintain below average interest-rate duration exposure. The 10-year US Treasury yield will finish the year at 1.9%. Spread product will continue to outperform high quality government bonds. Currencies: The US dollar will resume its weakening trend as growth momentum rotates from the US to the rest of the world. EUR/USD will finish the year at 1.25. Commodities: Brent will rise to $79/bbl by end-2021, 9% above current market expectations. While the lagged effects from the slowdown in Chinese credit growth earlier this year will weigh on base metals during the summer months, the long-term outlook for metals is positive. Favor gold over cryptos as an inflation hedge. I. Macroeconomic Outlook Global Vaccination Campaign Kicks Into High Gear Nearly 18 months after the pandemic began, the global economy is on the mend. In its latest round of forecasts released on May 31st, the OECD projects that the global economy will expand by 5.8% this year, up from its March projection of 5.6%. The OECD also bumped up its growth forecast for 2022 from 4% to 4.4%. After a rough start, the vaccination campaign is progressing well in most advanced economies (Chart 1). The US and the UK were the first major developed economies to roll out the vaccines, followed by Canada and the EU. While Japan has lagged behind, the pace of vaccinations has picked up lately. Twenty percent of the Japanese population has now received at least one dose. Developing economies are still struggling to secure enough vaccines. Fortunately, this problem should abate over the next six months. The Global Health Innovation Center at Duke University estimates that pharmaceutical companies are on track to produce more than 10 billion vaccine doses this year (Chart 2). While perhaps not enough to inoculate everyone who wants a jab, it will suffice in providing protection to the most vulnerable members of society – the elderly and those with pre-existing medical conditions. Chart 1The Vaccination Campaign Is Progressing Well In Most Developed Economies The Vaccination Campaign Is Progressing Well In Most Developed Economies The Vaccination Campaign Is Progressing Well In Most Developed Economies Chart 2Vaccine Makers Are On Track To Produce Over 10 Billion Doses In 2021 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal New Variants And Vaccine Hesitancy Are Risks Novel strains of the virus remain a concern. First identified in India, the so-called “Delta variant” is spreading around the world. The number of new cases in the UK, where the Delta variant accounts for over 90% of all new infections, is rising again (Chart 3). The latest outbreak has forced the government to postpone “Freedom Day” from June 21st to July 19th (Chart 4). Chart 3The Number Of New Cases In The UK Is Rising Anew 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 4Dismantling Of Lockdown Measures Occurring At Varying Pace 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal     It is highly likely that the Delta variant will produce another wave of cases in the US this summer. Despite ample availability, one-third of Americans over the age of 18 have yet to receive a single dose of a vaccine. As is the case with most everything in the United States, the question of whether to be inoculated has become politicized. In many Republican-leaning states, more than half the population remains unvaccinated (Chart 5). Chart 5The US Politicization Of Vaccines Raises The Risk From COVID-19 Variants 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Vaccine hesitancy will likely diminish as the evidence of their effectiveness continues to mount. According to analysis by the Associated Press using CDC data, fully vaccinated people accounted for less than 1% of the 18,000 COVID-19 deaths in the US in May. A study out of the UK showed that two doses of the Pfizer-BioNTech vaccine was 96% effective against hospitalization from the Delta variant, while the Oxford-AstraZeneca vaccine was 92% effective. While another wave of the pandemic will curb growth this summer, the economic impact will be far smaller than in the past. At this point, the initial terror of the pandemic has faded. Politically, it will be more difficult to justify lockdowns in countries such as the US where almost everyone who wants a vaccine has already been able to get one. Macro Policy Outlook: Tighter But Not Tight After cranking the fire hose to full blast during the pandemic, policymakers are looking to scale back support. On the fiscal side, governments are slowly starting to rein in budget deficits. The IMF expects the fiscal impulse in advanced economies to average -4% of GDP in 2022, implying an incrementally tighter fiscal stance (Chart 6). Chart 6Budget Deficits Set To Decline, But Remain High By Historic Standards 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Tighter does not necessarily mean tight, however. The IMF sees advanced economies running an average cyclically-adjusted primary budget deficit of 2.6% of GDP between 2022 and 2026, compared to an average deficit of 1.1% of GDP between 2014 and 2019. In the US, Congress is debating an infrastructure bill, a key element of President Biden’s “Build Back Better” agenda. If the bill fails to move out of the Senate, our geopolitical strategists expect Congress to use the reconciliation process to pass most of Biden’s legislative program. This should result in an additional 1.3% of GDP in federal spending per year over the next 8 years, offset only partly by higher taxes. Chart 7EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 8Japanese PMIs Stuck In The Mud Japanese PMIs Stuck In The Mud Japanese PMIs Stuck In The Mud In the euro area, the IMF expects fiscal policy to remain structurally looser by nearly 2% of GDP in the post-pandemic period. After six months of parliamentary debates, all 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 7). Most of the money will be spent on public investment projects with high fiscal multipliers. Japan has a habit of tightening fiscal policy at exactly the wrong moment, with the October 2019 hike in the sales tax from 8% to 10% being no exception. Unlike in other developed economies, both the Japanese manufacturing and services PMI remain stuck in the mud (Chart 8). The odds are rising that Prime Minister Yoshihide Suga will announce a major stimulus package after the Olympic Games and ahead of the general election due by October 22nd. China: Normalization Not Deleveraging Chart 9China: Weak Infrastructure Spending Should Pick Up China: Weak Infrastructure Spending Should Pick Up China: Weak Infrastructure Spending Should Pick Up In China, strong export growth, propelled by the shift in global spending towards manufactured goods during the pandemic, allowed the government to tighten fiscal policy modestly in the first half of the year. Looking out, fiscal policy should turn more stimulative. Local governments used only 16% of their bond issuance allocation between January and May, compared with 59% over the same period last year and 40% in 2019. Proceeds should benefit infrastructure spending, which has been on the weak side in recent years (Chart 9). After a sharp decline, Chinese credit growth should stabilize in the second half of the year. The current pace of credit growth of 11% is near its 2018 lows and is broadly in line with nominal GDP growth (Chart 10). Given that the authorities have stated their desire to stabilize the ratio of credit-to-GDP, they are unlikely to proactively suppress credit growth further. The recent decline in the 3-month SHIBOR, which usually moves in the opposite direction of credit growth, is evidence to this effect (Chart 11). Chart 10Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chinese Credit Growth Should Stabilize In The Second Half Of The Year Chart 11China: Easing Off The Brakes? China: Easing Off The Brakes? China: Easing Off The Brakes? Nevertheless, changes in fiscal and credit policy tend to affect the Chinese economy with a lag (Chart 12). Thus, the tightening in fiscal policy and the deceleration in credit growth that occurred early this year could still weigh on economic activity during the summer months. Chart 12China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag China: Changes In Fiscal And Credit Policy Affect The Economy With A Lag Don’t Sweat The Dot Plot Markets interpreted the June FOMC meeting in a hawkish light. Both the 2-year and 5-year yield jumped 10 basis points following the meeting (Table 1). The US dollar, which is quite sensitive to changes in short-term rate expectations, strengthened by nearly 2%. In contrast, long-term bond yields declined following the meeting, with the 10-year and 30-year bond yield falling by 6 and 19 basis points, respectively. Table 1Change In Yields Following June FOMC Meeting 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal As long duration assets, stocks take their cues more from long-term yields than short-term rates. Hence, it was not surprising that equities held their ground, and that growth stocks reversed some of their underperformance against value stocks this year. Chart 13Markets Interpreted The June FOMC Meeting In A Hawkish Light Markets Interpreted The June FOMC Meeting In A Hawkish Light Markets Interpreted The June FOMC Meeting In A Hawkish Light This publication agrees with BCA’s bond strategists that the market overreacted to the changes in the Fed’s projections (aka “the dots”). As Chair Powell himself noted during the press conference, the dot plot is “not a great forecaster of future rate moves,” before adding that “Lift-off is well into the future.” The market is currently pricing in 105 basis points of tightening by the end of 2023. Prior to the meeting, investors were expecting 85 basis points in rate hikes (Chart 13). The regional Fed presidents tend to be more hawkish than the Board of Governors. Our guess is that Jay Powell himself only penciled in one hike for 2023. Lael Brainard, who may be replacing Powell next year, likely projects no hikes for 2023. The Path To Full Employment Chart 14The Divergence Of Goods And Services Spending The Divergence Of Goods And Services Spending The Divergence Of Goods And Services Spending Rather than obsessing over the dots, investors should focus on the questions that will actually drive Fed policy, namely how long it takes the US economy to return to full employment and what happens to inflation in the interim and beyond. There is a lot of uncertainty over these questions – both on the demand side (how fast will spending recover?) and the supply side (how much labor market slack is there and how quickly can firms ramp up hiring?). On the demand side, the pandemic led to unprecedented changes in household spending and saving behavior. As Chart 14 shows, goods spending surged while services spending collapsed. Overall spending declined, and together with increased transfer payments, savings ballooned. As of May, US households were sitting on $2.5 trillion in excess savings. Looking at disaggregated bank deposit data as a proxy for the distribution of household savings, the wealthiest 10% of households accounted for about 70% of the increase in savings between Q1 of 2020 and Q1 of 2021 (Chart 15). Given that richer households have relatively low marginal propensities to spend, this suggests that a large fraction of these excess savings will remain unspent. Nevertheless, $2.5 trillion is a lot of money – it’s equal to almost 17% of annual consumption. Hence, even if a third of this cash hoard were to make its way into the economy, it could buoy aggregate demand significantly. Chart 15Excess Savings Have Mostly Flowed To The Rich 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal A Labor Market Puzzle Turning to the supply side, there were over 4% fewer people employed in the US in May than in January 2020 (Chart 16). On the face of it, this would suggest the presence of a significant amount of labor market slack. Chart 16US Employment Still More Than 4% Below Pre-Pandemic Levels 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Yet, the NFIB small business survey tells a different story. It revealed that 48% of firms reported difficulty in filling vacant positions in May, the highest percentage of respondents in the 46-year history of the survey (Chart 17). Chart 17US Labor Market Shortages (I) US Labor Market Shortages (I) US Labor Market Shortages (I) Chart 18US Labor Market Shortages (II) US Labor Market Shortages (II) US Labor Market Shortages (II)   Along the same lines, the nationwide job openings rate reached a record high of 6% in April, up from 4.5% in January 2020. The quits rate, a good proxy for worker confidence, is also at a record high (Chart 18). How does one reconcile the low level of employment with other data pointing to a tight labor market? As we discussed in a report two weeks ago, four explanations stand out: Generous unemployment benefits, which have depressed labor force participation among low-wage workers (Chart 19). Chart 19Labor Scarcity Prevalent In Low-Wage Sectors 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 20School Closures Have Curbed Labor Supply 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Pandemic-related school closures. As Chart 20 shows, they have had a noticeable impact on labor force participation among women with young children. Reduced immigration. At one point during the pandemic, visa issuance was down 99% from pre-pandemic levels (Chart 21). An increase in early retirements. We estimate that about 1.5 million more workers retired during the pandemic than would have been expected based solely on demographic trends (Chart 22). Chart 21US Migrant Worker Supply Is Depressed 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 22The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement The Pandemic Accelerated Early Retirement All but the last effect is likely to be fleeting. Enhanced unemployment benefits expire in September; President Biden has reversed President Trump’s ban on most worker visas; and schools should fully reopen by the fall. And even for the retirement effect, most recent retirees were approaching retirement age anyway. Thus, there will likely be fewer incremental retirements over the next few years. A Speed Limit To Hiring? Assuming that a large fraction of sidelined workers return to the labor market in the fall, how fast will firms be able to hire them? In general, we are skeptical of arguments claiming that there is much of a speed limit to the pace of hiring. Chart 23There Is A Lot Of Churn In The Labor Market There Is A Lot Of Churn In The Labor Market There Is A Lot Of Churn In The Labor Market There is a lot of churn in the labor market. Gross job flows are much larger than net flows. Between 2015 and 2019, 66.1 million people were hired on average per year compared with 59.6 million who quit or were discharged. Churn is especially strong in the retail and hospitality sectors, the two segments that account for the bulk of today’s shortfall in jobs. In April of this year, retailers hired nearly 800,000 workers. An additional 1.42 million workers found jobs in the leisure and hospitality sectors. This is equivalent to 5.3% and 10.1% of total employment in those sectors, respectively (Chart 23). And remember, we are talking about only one month’s worth of hiring. During past V-shaped recoveries, employment growth often surpassed 5% on a year-over-year basis (Chart 24). Such a growth rate would produce net 670K new jobs per month, enough to restore full employment by mid-2022. Chart 24V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries V-Shaped Recoveries Are Generally Followed By Strong Labor Market Recoveries The Fed’s Three Criteria For Lift-Off In August of 2020, the Fed formally adopted a “flexible average inflation targeting” framework. It seeks to offset periods of below-target inflation with periods of above-target inflation. The goal is to better anchor long-term inflation expectations, while giving households and firms more clarity over where the price level will be many years out. In the spirit of this new framework, the Fed has made it clear that it needs to see three things before it considers raising rates: The labor market must be at “maximum employment” 12-month PCE inflation must be above 2% The FOMC must expect inflation to remain above 2% for some time If the US economy achieves full employment by the middle of next year, the first criterion will be satisfied. PCE inflation clocked in at 3.9% in May, so at least for now, the second criterion is satisfied as well. The big question concerns the third criterion. How Transitory Is US Inflation Likely To Be? As Chart 25 shows, more than half of the increase in the CPI in April and May can be explained by higher vehicle prices, along with a rebound in pandemic-affected service prices (airfares, hotels, and event admissions). Outside those sectors, the level of the CPI still remains below its pre-pandemic trend, while the level of the PCE deflator is barely above it (Chart 26). Aside from a few low-wage sectors such as retail and hospitality, overall wage growth remains contained. Neither the Atlanta Fed Wage Growth Tracker nor the Employment Cost Index – the two cleanest measures of US wage inflation – is signaling a brewing wage-price spiral (Chart 27). Chart 25Rebounding Pandemic-Affected Services Prices Are Pushing Up Overall CPI 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 26AUnwinding Of "Base Effects" (I) Unwinding Of "Base Effects" (I) Unwinding Of "Base Effects" (I) Chart 26BUnwinding Of "Base Effects" (II) Unwinding Of "Base Effects" (II) Unwinding Of "Base Effects" (II) Chart 27No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now Chart 28Rising Oil Prices Have Fueled The Jump In Inflation Expectations 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal   Chart 29Inflation Expectations Back Below The Fed's Target Zone Inflation Expectations Back Below The Fed's Target Zone Inflation Expectations Back Below The Fed's Target Zone Chart 30A Top In Inflation Expectations? A Top In Inflation Expectations? A Top In Inflation Expectations? While inflation expectations have risen, they should fall in the second half of the year as gasoline prices descend from their seasonal highs (Chart 28). Market expectations of inflation have already dipped back below the Fed’s comfort zone (Chart 29). Inflation expectations 5-to-10 years out in the University of Michigan’s Survey of Consumers also dropped from 3% in May to 2.8% in June (Chart 30). Overall producer price inflation should decline. Chart 31 shows that lumber prices, steel prices, agriculture prices, and memory chip prices have all peaked. Taken together, all this suggests that the recent surge in inflation is indeed likely to be “transitory.” Chart 31Input Prices Have Rolled Over Input Prices Have Rolled Over Input Prices Have Rolled Over Risk-Management Considerations Favor A “Go Slow” Approach Chart 32Market Participants See An Even Lower Terminal Rate Than The Fed Market Participants See An Even Lower Terminal Rate Than The Fed Market Participants See An Even Lower Terminal Rate Than The Fed The financial press often characterizes the Fed’s monetary policy as ultra-accommodative. With policy rates near zero, one would be forgiven for agreeing. However, the reality is that neither the Fed nor, for that matter, most market participants think that monetary policy is all that easy. Using expectations for the terminal Fed funds rate as a proxy for the neutral rate of interest, the Fed’s estimate of the terminal rate has fallen from 4.3% in 2012 to 2.5% at present (Chart 32). Surveys of primary dealers and other market participants suggest that investors think the terminal rate is even lower than what the Fed believes it to be. It is an open question as to whether the neutral rate really is as low as widely believed. But if it is, raising rates prematurely would be a grave mistake. Given the zero lower bound constraint on nominal policy rates, the Fed would be hard-pressed to ease monetary policy by enough to respond to any future deflationary shock. In contrast, if inflation proves to be more persistent, raising rates to cool the economy would be relatively straightforward. All this suggests that the Fed is likely to maintain its “go slow” approach. This publication expects tapering of QE to begin early next year, with no rate hike until December 2022 or early 2023. Other Central Banks Constrained By The Fed Chart 33Long-Term Inflation Expectations Remain Subdued Long-Term Inflation Expectations Remain Subdued Long-Term Inflation Expectations Remain Subdued The Fed’s dovish bias limits the ability of other developed economy central banks to tighten monetary policy. For some central banks, such as the ECB and BoJ, raising rates is the last thing they want to do. In both the euro area and Japan, long-term inflation expectations remain well below target (Chart 33). The Bank of England is in a better position to tighten monetary policy than the ECB. Inflation expectations are relatively high in the UK and a frothy housing market poses a long-term threat to economic stability. Nevertheless, the need to maintain a competitive currency to facilitate post-Brexit economic adjustments will limit the BoE’s ability to raise rates. Moreover, the departure of BoE Chief Economist, Andy Haldane, from the MPC will silence the sole voice sounding the alarm over rising inflation. Among the G7 economies, the Bank of Canada is the closest to raising rates. After a slow start, the vaccination campaign is now progressing well there. Property prices have gone through the roof. The Western Canada Select oil price has reached the highest level since 2014. The discount to WTI has shrunk from a peak over 50% in November 2018 to about 20% in recent weeks. The Bank of Canada has already begun tapering asset purchases. While concerns about a stronger loonie will tie the BoC’s hands to some extent, the first rate hike is still likely in mid-2022. II. Financial Markets A. Portfolio Strategy The Golden Rule embraced by this publication is “remain bullish on stocks as long as growth is likely to remain strong for the foreseeable future.” Historically, bear markets rarely occur outside of recessions (Chart 34). With both fiscal and monetary policy still supportive, and households in many countries sitting on plenty of dry powder, the odds that the global economy will experience a major downturn in the next 12 months are low. Chart 34Recessions And Bear Markets Tend To Overlap 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal That said, we do acknowledge that the risk-reward profile for equities has deteriorated since the start of the year. Global stocks have risen 12% year-to-date, implying that investors have priced in an increasingly optimistic economic outlook. Our equity valuation indicator points to very poor long-term future returns, particularly in the US (Chart 35). Chart 35ALong-Term Expected Returns Are Nothing To Write Home About (I) Long-Term Expected Returns Are Nothing To Write Home About (I) Long-Term Expected Returns Are Nothing To Write Home About (I) Chart 35BLong-Term Expected Returns Are Nothing To Write Home About (II) Long-Term Expected Returns Are Nothing To Write Home About (II) Long-Term Expected Returns Are Nothing To Write Home About (II) Democrats in Congress will likely use the reconciliation process to raise corporate taxes. While this is unlikely to cause major problems for the economy, it could weigh on stocks. As we discussed in a past report, neither analyst earnings estimates nor market expectations are baking in much impact from higher tax rates. Meanwhile, economic growth has peaked in the US and China, and will peak in the other major economies over the balance of 2021. Slower growth is usually associated with lower overall equity returns (Table 2). Stocks are also likely to face headwinds as spending shifts back from goods to services. Goods producers are overrepresented in stock market indices compared to the broader economy. Table 2The Economic Cycle And Financial Assets 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal The fact that global growth is peaking at exceptionally high levels will soften the blow for stocks. Likewise, the need to rebuild inventories and satisfy pent-up demand for some manufactured goods that have been in short supply will keep goods production from falling too drastically. Nevertheless, investors who have been maximally overweight stocks should consider paring exposure by raising cash. Only a modest equity overweight is appropriate going into the second half of this year. B. Equity Sectors, Regions, And Styles While we continue to favor cyclical equity sectors over defensives, non-US over the US, and value over growth, our conviction is lower than it was at the start of the year. In the near term, the lagged effects from the slowdown in Chinese credit growth could weigh on global cyclicals. Cyclicals could also stumble as the Delta variant rolls through the US and other countries. In addition, the US dollar could sustain recent gains as investors continue to fret that the Fed is turning hawkish. A stronger dollar is usually bad for cyclicals and non-US stocks (Chart 36). Chart 36Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Cyclical And Non-US Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 37Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment Bank Shares Thrive in A Rising Yield Environment   Ultimately, as discussed earlier in this report, the Fed is likely to push back against the market’s hawkish interpretation of its dot plot. The resulting reflationary impulse should cause the dollar to weaken over a 12-month horizon while allowing for a re-steepening of the yield curve. Higher long-term bond yields tend to benefit banks, which are overrepresented in value indices (Chart 37). A stabilization in credit growth and more stimulative Chinese policy later this year should temper concerns about EM growth. Greater access to vaccines will also allow more EM economies to partake in reopening euphoria, thus benefiting local EM stock markets and global cyclicals. C. Fixed Income If stocks are pricey, government bonds are even more dear. Real yields are negative in most G10 economies. And while persistently higher inflation is not an imminent threat, it is a longer-term risk that bond valuations are not discounting. We expect the 10-year US Treasury yield to rise to 1.9% by the end of the year, above current market expectations of 1.61%. As of today, we are expressing this view by going short the 10-year Treasury note in our trade table. US Treasuries have a higher beta than most other government bond markets (Chart 38). Treasury yields tend to rise more when global bond yields are moving higher and vice versa. Given our expectation that global growth will remain solidly above trend over the next 12 months, fixed-income investors should underweight high-beta bond markets such as the US and Canada, while overweighting the euro area and Japan. Chart 38US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets US Treasuries Have A Higher Beta Than Most Other Government Bond Markets BCA’s bond strategists see more upside from high-yield bonds than for investment grade. While high-yield spreads are quite tight, they are still pricing in a default rate of 2.9%. This is more than their fair-value default estimate of 2.3%-to-2.8% (Chart 39). It is also above the year-to-date realized default rate of 1.8%. Chart 39Spread-Implied Default Rate Spread-Implied Default Rate Spread-Implied Default Rate Our bond team sees USD-denominated EM corporate bonds as being attractively priced relative to domestic investment-grade corporate bonds with the same duration and credit rating. They prefer EM corporates to EM sovereigns in the A and Baa credit tiers, while preferring EM sovereigns over EM corporates in the Aa credit tier. Investors willing to take on foreign-exchange risk should consider EM local-currency bonds. As we discuss next, a weaker US dollar over the next 12 months should translate into stronger EM currencies. D. Currencies Four forces tend to drive the US dollar over cyclical horizons of about 12 months: Growth: As a countercyclical currency, the dollar typically does poorly when global growth is strong. This is especially the case when growth is rotating away from the US to other countries (Chart 40). Bloomberg consensus estimates imply that the US economy will transition from leader to laggard over the coming months, which is dollar bearish (Table 3). Chart 40The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Table 3Growth Is Peaking, But At A Very High Level 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Interest Rate Differentials: The trade-weighted dollar tends to track the real 2-year spread between the US and its trading partners (Chart 41). It is unlikely that US real rates will fall much from current levels. However, the current level of spreads is already consistent with a meaningfully weaker dollar. Chart 41Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Balance Of Payments: The US trade deficit has increased significantly over the past year (Chart 42). Equity inflows have been helping to finance the trade deficit (Chart 43). However, if stronger growth abroad causes equity flows to move out of the US, the dollar will suffer. Chart 42The US Trade Deficit Has Increased Significantly The US Trade Deficit Has Increased Significantly The US Trade Deficit Has Increased Significantly Chart 43Equity Inflows Have Helped Finance The Trade Deficit Equity Inflows Have Helped Finance The Trade Deficit Equity Inflows Have Helped Finance The Trade Deficit Momentum: Being a contrarian is a losing strategy when it comes to trading the dollar. This is because the US dollar is a high momentum currency (Chart 44). The dollar usually continues to weaken when it is trading below its various moving averages and sentiment is bearish (Chart 45). At present, while the dollar is near its short-term moving averages, it is still below its long-term moving averages. Sentiment is bearish, but has come off its lows. On balance, the technical picture for the dollar is slightly negative.   Chart 44The Dollar Is A High Momentum Currency 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 45ABeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (I) Chart 45BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Being A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II) Adding it all up, we expect the dollar to weaken over a 12-month horizon. The dollar’s downdraft will likely begin in earnest during the fall when Chinese policy turns more stimulative and fears that the Fed has turned hawkish subside. We expect EUR/USD to finish the year at 1.25. GBP/USD should hit 1.50. Both EM and commodity currencies should also do better. The lone laggard among “fiat currencies” will be the yen. As a highly defensive currency, the yen usually struggles when global growth is firm. Chart 46To This Day, Most Crypto Payments Are Made To Criminals 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal What about cryptocurrencies? I debated the topic with my colleague, Dhaval Joshi, in early June. To make a long story short, I think it is highly unlikely that cryptos will ever thrive. More than 13 years since Bitcoin was created, cryptos continue to be mainly used to facilitate illicit transactions. According to Chainalysis, there were fewer cryptocurrency payments processed by merchants in 2020 than in 2017 (Chart 46). Meanwhile, Bitcoin mining continues to produce significant environmental damage (Chart 47). And if there is any place where there is hyperinflation, it is in the creation of new cryptocurrencies. There are over 5000 cryptocurrencies at last count, double the number at this time last year (Chart 48). We are currently short Bitcoin in our trade table.   Chart 47Bitcoin And Ethereum: How Dare You! 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 48Hyperinflation In New Cryptocurrency Creation 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal E. Commodities Structurally, oil faces a bleak future. Transport accounts for about 60% of global oil consumption. The shift to electric vehicles will undermine this key source of oil demand. Cyclically, however, crude prices could still rise as the global economic recovery unfolds. Supply remains quite tight, reflecting both OPEC vigilance and the steep drop in oil and gas capex of recent years (Chart 49). Bob Ryan, BCA’s chief commodity strategist, expects Brent to rise to $79/bbl by the end of the year, which is 9% above current market expectations (Chart 50). Chart 49Oil And Gas Companies Curtailed Capex In Recent Years 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Chart 50Oil Prices Still Have Room To Run Oil Prices Still Have Room To Run Oil Prices Still Have Room To Run Chart 51Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom Chinese Metal Consumption Up 5-Fold Since The 2000s Commodity Boom In contrast to oil, the long-term outlook for base metals is favorable. A typical electric vehicle requires four times as much copper as a typical gasoline-propelled vehicle. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of current annual copper production. Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then (Chart 51). In the near term, however, base metals have to grapple with the lagged effects of slower Chinese credit growth (Chart 52). We downgraded base metals to neutral on May 28 and are currently long global energy stocks via the IXC ETF versus global copper miners via the COPX ETF. We expect to reverse this trade by the fall. We are generally positive on gold. Since peaking last August, the price of gold has fallen more than one might have expected based on movements in real bond yields (Chart 53). Gold will also benefit from a weaker dollar later this year. Lastly, and importantly, gold should retain its standing as a good inflation hedge. Chart 52Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Tighter Chinese Credit Will Be A Headwind For Base Metals Over The Summer Months Chart 53Gold Prices Tend To Track Real Rates Gold Prices Tend To Track Real Rates Gold Prices Tend To Track Real Rates Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Special Trade Recommendations 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal Current MacroQuant Model Scores 2021 Third Quarter Strategy Outlook: The Path To Normal 2021 Third Quarter Strategy Outlook: The Path To Normal

Dear Client, China Investment Strategy will take a summer break next week. We will resume our publication on July 14th. Best regards and we wish you a happy and healthy summer. Jing Sima, China Strategist   Highlights A USD rebound and higher domestic bond yields pose near-term challenges to Chinese risk assets. A sharp deceleration in credit growth in the past seven months will lead to weaker-than-expected data from China’s old-economy sectors in the second half of the year.  Robust global trade has propelled Chinese exports, allowing the country to pursue financial deleverage and structural reforms. However, next year policymakers will face increased pressure to support the domestic economy as the global economic recovery peaks and demand slows. Investors should maintain an underweight stance towards Chinese stocks in 2H21, but remain alert to any improvements in China’s policy tone.  An easing monetary policy may signal a potential upgrade catalyst in 1H22. Feature Most recent macro figures confirm that China’s impressive economic upcycle has peaked. We expect that the official manufacturing and non-manufacturing PMIs, which will be released as this report is published, will come in modestly down. We maintain the view that a major relapse in economic activity is unlikely, but the strong tailwinds that have propelled China's recovery since Q2 last year have since abated and will lead to softer growth. Meanwhile, the rate of economic and export expansions has given Chinese policymakers confidence to scale back leverage and continue with market reforms. In the second half of the year, investors' sentiment towards Chinese stocks will be tested based on three risks: A rebound in the US dollar index. A tighter liquidity environment and higher interest rates. A weakening in macro indicators beyond market expectations. As the global economic recovery peaks into 2022, pressures to support the domestic economy will become more urgent if policymakers want to maintain an average rate of 5% real GDP growth in 2020 - 2022. The current policy settings are not yet favorable to overweight Chinese risk assets. Major equity indexes remain richly valued and the market could easily correct if domestic rates move higher. However, signs of policy easing may emerge by yearend, which would prompt us to shift our view to overweight Chinese stocks in both absolute and relative terms. The Case For A Dollar Rebound On a tactical basis (next three months), a rebound in the US dollar index may curb investors’ enthusiasm for Chinese stocks. A stronger dollar will give the RMB’s appreciation some breathing room and will be reflationary for China’s economy. However, in the short term a stronger USD will also lead to weaker foreign inflows to China’s equity markets. Chinese stock prices have become more closely and negatively correlated with the dollar index since early 2020 (Chart 1). A weaker dollar is usually accompanied by a global economic upturn and a higher risk appetite from investors, propelling more foreign portfolio flows to emerging markets (which includes Chinese risk assets). Although foreign inflows account for a small portion of the Chinese A-share market cap, global institutional investors’ sentiment has become more influential and has led fluctuations in Chinese onshore stock prices (Chart 2). Chart 1Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Closer Correlations Between Chinese Stocks And The Dollar Index Chart 2Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Foreign Investors Matter To Chinese Onshore Stock Prices Chart 3Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff Rising Market Expectations For The Fed's Rate Liftoff The US Federal Reserve delivered a slightly more hawkish surprise at its June FOMC meeting with the message that it will move the projected timing of its first fed fund rate liftoff from 2024 to 2023. Since then, market expectations have shifted from growth and inflation to focusing on the next monetary policy tightening phase, with the short end of the US yield curve rising sharply (Chart 3). Given that currency markets trade off the short end of the yield curve, higher US interest rate expectations will at least temporarily lift the US dollar. The timing and pace of the Fed’s tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the US central bank’s definition of “maximum employment.” BCA’s US Bond Investment strategist anticipates that sizeable and positive non-farm payroll surprises will start in late summer/early fall, which will catalyze a move higher in bond yields. As such, we expect additional upside risks in the dollar index in the coming months, which will discourage foreign investors’ appetite for Chinese equities. Bottom Line: A rebound in the dollar index will be a near-term downside risk to Chinese stocks. Risk Of Higher Chinese Interest Rates Another near-term risk to Chinese stock prices is a tightening in domestic liquidity conditions and a rebound in interest rates, particularly in Q3. Chart 4The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus So far this year the PBoC has kept liquidity conditions accommodative to avoid massive debt defaults, while allowing a faster deceleration in the pace of credit expansion and a sharp contraction in shadow banking (Chart 4). In the coming months, however, the trend may reverse. Even though we do not think China’s current inflation and growth dynamics warrant meaningful and sustainable monetary policy tightening, there is still room for rates to normalize to their pre-pandemic levels in the next few months. Our view is based on the following:  First, there was a major delay in local government bond issuance in the first five months of the year. The supply of government bonds will pick up meaningfully in Q3 to meet the annual quota for 2021. An increase in government bond issuance will remove some liquidity from the banking system because the majority of these local government bonds are purchased by commercial banks. Adding to the liquidity gap is a large number of one-year, medium-term lending facility (MLF) loans that will be due in 2H21. Secondly, the PBoC may shift its policy tightening from reducing the volume of total credit creation (measured by total social financing) to raising the price of money. Credit growth (on year-over-year basis) in the first five months of 2021 dropped by three percentage points from its peak in Q4 last year, much faster than the 13-month peak-to-trough deceleration during the 2017/18 policy tightening cycle. As the rate of credit creation approaches the government’s target for the year, which we expect around 11%, the pressure to further compress credit expansion has eased into 2H21. China’s policy agenda is still focused on de-risking in the financial and real estate sectors, therefore, we expect policymakers to keep overall monetary conditions restrictive by raising the price of money. Furthermore, we do not rule out the possibility of a hike in mortgage rates. Chart 5Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Lastly, as the Fed prepares market expectations for its rate liftoff and China’s domestic economy is still relatively solid, the PBoC may seize the opportunity to guide market-based interest rates towards their pre-pandemic levels. Thus, the market will likely price in tighter liquidity conditions while lowering expectations for the economy and inflation. The short end of the yield curve will rise faster than the longer end, resulting in a flattening of the curve (Chart 5). There is a nontrivial risk that the market will react negatively to tighter liquidity conditions and rising bonds yields, particularly when the economy is slowing. We mentioned in previous reports that rising policy rates and bond yields do not necessarily lead to lower stock prices, if rates are rising while credit keeps expanding and corporate profit growth accelerates. However, currently credit impulse has decelerated sharply, and corporate profit growth has most likely peaked in Q2. Therefore, even a small increase in bond yields or market expectations of higher rates will likely trigger risk asset selloffs. Bottom Line: Bond yields will move higher in Q3, risking market selloffs. Chinese Economy Standing On One Leg China’s economic fundamentals also pose downside risks to Chinese stock prices. Macro indicators on a year-over-year comparison will soften further in 2H21 when low base effects wane, although they will weaken from very high levels. This year’s sharp credit growth deceleration will start to drag down domestic demand, with the risk of corporate profits disappointing the market. A positive tailwind from global trade prevented China's old economy from decelerating more in the first half of the year. It is reflected in the nominal imports and manufacturing orders components in the BCA Activity Index (Chart 6). However, while rising commodity prices boosted the value of Chinese imports, the volume of imports has been moving sideways of late (Chart 7). Chart 6Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Our BCA Activity Index Is Still Rising... Chart 7...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over ...But The Volume Of The Import Component Has Rolled Over Chart 8Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Export Growth Is Moderating From Current Level Moreover, China’s export volume is peaking as the reopening in other countries shifts consumer demand from goods to services. Strong export growth would likely decelerate and converge to global industrial production growth in the coming 12 months, even though a regression-based approach suggests that export growth will stay above trend-growth if global economic activity remains robust (Chart 8). All three components of the official Li Keqiang Index, which measures China’s industrial sector activity and incorporates electricity consumption, railway transportation and bank lending, have rolled over (Chart 9). Among the three components in BCA’s Li Keqiang Leading Indicator, only the monetary conditions index improved on the back of lower real rates. Contributions from the money supply and credit expansion components to the overall indicator have been negative (Chart 10). Chart 9The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... The Official Li Keqiang Index Is Weakening... Chart 10...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator ...So Is Our BCA Li Keqiang Leading Indicator Chart 11Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard Household Consumption Recovery Remains A Laggard The recovery in household consumption remains well behind the industrial sector in the current cycle (Chart 11). We expect consumption and services to continue recovering very gradually. Apart from China’s long-standing structural issues, such as sliding household income growth and a high propensity to save, the cyclical recovery in consumption is dependent on China’s domestic COVID-19 situation. The country is on track to fully vaccinate 40% of its population by the end of June and 80% by year-end (Chart 12). However, hiccups in the service sector recovery are expected through 2H21, given China’s “zero tolerance” policy on confirmed COVID cases, which could trigger sporadic local lockdowns (Chart 13). Chart 12China Is Racing To Reach “Full Inoculation Rate” By Yearend China Outlook: A Mid-Year Recap China Outlook: A Mid-Year Recap Chart 13Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Expect Some Hiccups In Service Sector Recovery In 2H21 Bottom Line: Any moderation in exports in the rest of 2021 may add to the slowdown in China’s economic activity. Don’t Count On Fiscal Support Chart 14Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 Fiscal Spending Has Been Disappointing In 1H21 During the first five months of the year, fiscal spending has downshifted (Chart 14). The amount of local government special-purpose bonds (SPBs) issued was far less than in the same period of the past two years, and below this year’s approved annual quota. Although we expect fiscal support to increase into 2H21, backloading SPBs would qualify, at best, as a remedial measure rather than a meaningful boost to economic activity. The RMB3 trillion SPBs to be issued in 2H21 represent only about 10% of this year’s total credit expansion. To substantially boost credit impulse and economic activity, the pickup in SPB issuance will need to be accompanied by looser monetary policy and an acceleration in bank loans (Chart 15). We do not expect that liquidity conditions will remain as lax as in 1H21. Additionally, given that the central government’s focus is to rein in the leverage of local governments and their affiliated financial vehicles (LGFV), provincial officers have little incentive to take on more bank loans against a restrictive policy backdrop. Historically, a stronger fiscal impulse linked to hefty increases in local government bond issuance has not necessarily led to meaningful improvements in infrastructure investment, which has been on a structural downshift since 2017 (Chart 16). Following a V-shaped recovery in 2H20, the growth in infrastructure investment will likely continue to slide in 2H21 due to sluggish government spending. Chart 15Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Bank Loans Still Hold The Key To Stimulus Impulse Chart 16Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Bottom Line: There are no signs that the overall policy stance is easing to facilitate a higher fiscal multiplier from an upturn in local government bond issuance. As such, fiscal support for infrastructure spending and economic activity will disappoint in 2H21 despite more SPB issuance. Investment Conclusions Monetary conditions may tighten in Q3 although credit growth will decelerate at a slower pace. Pressures to support domestic demand will be more pronounced next year as tailwinds abate from the global recovery and domestic massive stimulus. Our view is that Chinese authorities will likely ease on the policy tightening brake towards the end of this year and perhaps even signal some reflationary measures in early 2022.  Therefore, while we maintain an underweight stance on Chinese stocks for the time being, investors should remain alert to any improvements in China's policy direction. In particular, any monetary policy easing by end this year/early 2022 may signal a potential catalyst to upgrade Chinese stocks to overweight in absolute terms. Although both Chinese onshore and investable equities are currently traded at a discount relative to global stocks, they are richly valuated compared with their 2017/18 highs (Chart 17). China's economy is slowing and the corporate sector has substantially increased its leverage in the past decade. We believe that the current discount in Chinese equities relative to global stocks is warranted. Chart 18 presents a forecast for A-share earnings growth in US dollars, based on earnings’ relationship with the official Li Keqiang index. The chart shows that while an earnings contraction is not probable, without more stimulus the growth rate may fall sharply in the next 12 months from its current elevated level. This aspect, combined with only a minor valuation discount relative to global stocks, paints an uninspiring outlook for Chinese onshore stocks. Chart 17Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chart 18An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook Our baseline view is that Chinese authorities will be more willing to step up policy supports into 2022. Fiscal impulse will likely turn negative for most major economies next year and global economic recovery will have peaked. In this scenario, both China’s economy and stocks will have the potential to outperform their global peers next year.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Dear client, In lieu of our weekly bulletin next Friday, I will be hosting a webcast on Tuesday, June 29 to discuss the latest trends in FX markets, given the hawkish shift by the Federal Reserve. I hope to answer your questions during this webcast. Kind regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights The hawkish shift by the Federal Reserve last week jolted the dollar higher, but our bias is that the rally will be quite short-lived. The primary reason is that US real rates will remain depressed, relative to the rest of the world, for the foreseeable future. The US balance of payments backdrop continues to deteriorate suggesting that the willingness by foreign concerns to fund the trade deficit will be a drag on the dollar. Global trade is staging a recovery. Historically, this has been synonymous with stronger global growth and a weaker dollar. Most countries are seeing foreign direct investment (FDI) inflows accelerate in the first few months of 2021, on the back of potential profitable investment projects. This is set to continue. The advantage appears to be particularly pronounced in commodity-producing countries that are witnessing a strong terms-of-trade tailwind. Feature Chart I-1The Dollar Rallied Hard On The Fed Shift On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments Last week, the Federal Reserve surprised markets with a hawkish shift. First, the median dots suggested at least two rate hikes by the end of 2023, a shift from the March communiqué where no rate hikes were expected until 2024. Second, the Fed revised its inflation forecast for 2021, from 2.4% to 3.4%, while suggesting that this should still be transitory. Longer-term inflation expectations were left largely unchanged. Finally, the discussion around tapering was acknowledged, which was interpreted as a sign that the Fed was inching closer to withdrawing monetary stimulus. The reaction in the FX market was violent. From a low of 90.5 last week, the DXY index rallied 2% and currently sits at 91.8. The most hit currencies were procyclical, even where central bankers have been more hawkish than the Fed, such as Norway and New Zealand (Chart I-1). Our initial take was that the market moves were a knee-jerk reaction, likely to be sustained in the coming weeks and months but would prove fleeting. As we finally digest the implications of the Federal Reserve’s shift, it is difficult to make the case for a sustainable rally in the US dollar. The jump in the dollar coincided with an upward revision in market expectations for rate hikes in 2022 and 2023. Markets now expect the Fed to lift interest rates by 34 bps in 2022 and an additional 51 bps in 2023. Notably, this is higher than what the market expected at the start of the year (Chart I-2, top panel). On the surface, this explains the dollar rally. But market interest rate expectations between the US and the rest of the world were largely unchanged, as real rates moved higher almost everywhere within the G10 (Chart I-2, bottom panel). From this perspective, the dollar rally was largely an overreaction. Higher inflation in the US, especially compared to the rest of the world, has usually been a bearish development for the dollar. The simple reason is that the fair value of the currency incrementally declines on a purchasing power parity basis. Therefore, the Federal Reserve’s adjustment higher of US inflation should not have reinvigorated bulls, unless they believe the Fed will actively move ahead of the inflation curve (Chart I-3). We did not get such a reading from last week’s release. And given that the US is generating the fastest inflation in the G10 and has the sole central bank targeting an inflation overshoot, our bias is that real rates will remain depressed for the foreseeable future Chart I-2Long-Term Rates Did Not Shift In Favor Of The Dollar Long-Term Rates Did Not Shift In Favor Of The Dollar Long-Term Rates Did Not Shift In Favor Of The Dollar Chart I-3Higher Inflation In The US Is Negative For The Greenback Higher Inflation In The US Is Negative For The Greenback Higher Inflation In The US Is Negative For The Greenback The Fed suggested that discussions have begun around tapering, but again, this was little reason for a rally in the dollar. Market participants had already expected tapering to begin sometime next year (Table I-1A and I-1B). Meanwhile, the Fed reiterated that any tapering discussions will be communicated well in advance. It is also worth noting that the Fed is lagging other central banks in tapering asset purchases, notably the Bank of Canada. Table 1AMarket Participants Already Expect The Fed To Taper Next Year On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments Table I-1BMarket Participants Already Expect The Fed To Taper Next Year On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments The above analysis suggests that the Fed provided an excuse for an oversold dollar to bounce higher, rather than trigger a sea change in the currency outlook. So, from a tactical perspective, the rally could continue, pushing us towards 94 on the DXY. However, longer term, the underlying drivers of the dollar suggest a bearish view remains appropriate. This week’s report focuses on one such longer-term driver – the balance of payments. The US trade deficit continues to widen at an accelerating pace, while improving in many other countries. From this perspective, the willingness by foreign concerns to fund the trade deficit will continue to be a drag on the dollar. Global Trade And The Dollar In Q1 2021, global trade was higher than pre-crisis levels, rising 10% year-on-year. According to the United Nations Conference on Trade and Development (UNCTAD), the strong rebound continues to be driven by the strong exports from East Asian economies. These trends are expected to continue in the near-term, especially once trade in services can resume in earnest on the back of vaccination progress. Chart I-4US Balance Of Payments Are Negative For The Dollar On The Fed Shift, And Balance Of Payments On The Fed Shift, And Balance Of Payments Global FDI inflows should also begin to rebound going into next year, following a tumultuous decline in 2020. According to UNCTAD, global FDI inflows plunged by 35%, bringing total FDI inflows to below US$1 trillion. As reinvested earnings make up a huge share of total FDI, the earnings decline last year curtailed flows. Looking ahead, UNCTAD expects FDI flows to recover fully in 2022, under their optimistic scenario. Over the much longer term, the headwinds to trade and FDI flows remain, including rising protectionism, global onshoring of production and geopolitical tensions. De-globalization is here to stay, as policymakers promote more regulation and intervention in key industries. That said, over the next few years, balance of payments dynamics will remain important and could be the key driver for currencies, as investors become more discerning between countries and sectors with a high return on capital and those without. In this report, we look at the balance-of-payment dynamics in the G10. Specifically, the basic balance, which takes the sum of the current account and net long-term capital inflows (and therefore tends to measure the underlying competitiveness of a currency more accurately). On this basis, Sweden, the euro area, Australia and Norway sport the best surpluses, while the US is the worst (Chart I-4). United States Chart I-5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US basic balance is deteriorating at an accelerating pace (Chart I-5). Just this week, the current account balance for Q1 came in at -$195.7 billion, the widest in over a decade. This is also occurring at a time when FDI inflows are deteriorating. If this trend continues, it could continue to undermine the US currency. The basic balance is approaching -4% of GDP. This has reversed most of the improvement in the basic balance since the Global Financial Crisis. This confirms our bias that the dollar likely put in a major top last year and has entered a multi-year decline. On portfolio flows, the most recent TIC data show that US Treasurys were aggressively bought in March and April by foreigners. Equity inflows also remain strong. However, should US real rates remain deeply negative, this will curtail foreign appetite for US government bonds, and require an adjustment lower in the dollar.           Euro Area Chart I-6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The euro area maintains a structural current account surplus, which has been improving in recent quarters (Chart I-6). Since the beginning of the year, the surplus has increased from €5.8 billion to €31.4 billion in April. Meanwhile, after about two decades of underinvestment in the euro area, FDI inflows are now at the strongest level, to the tune of about 2% of GDP. This is nudging the euro area’s basic balance to a record 4% of GDP. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. This is likely to persist, as strong FDI inflows, especially in the green energy sector, continue. Portfolio investment has turned strongly negative in recent quarters, but this is likely a crowding out of bond investors by strong purchases from the ECB. Meanwhile, the euro area generates a surplus of savings that need to be reinvested abroad.             Japan Chart I-7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Ever since the Fukushima crisis, the Japanese trade balance has been severely hampered by rising energy imports. The key pillar for the basic balance surplus is income receipts from Japan’s large investment positions abroad. This should continue to keep the basic balance in surplus, albeit at lower levels than a decade ago (Chart I-7). Going forward, the Japanese trade balance should keep improving as exports maintain their strong growth. On the service side of the equation, foreign visitors should also increase, especially as the Olympics move ahead. At their peak, foreign visitors were about 2% of the Japanese population, compared to almost nil today. The improvement in the goods and services balance should nudge the basic balance above 2% of GDP in the coming quarters. Net portfolio investments are accelerating, especially given the recent underperformance of Japanese equities (making them cheap), and positive real rates from longer-term Japanese corporate and government bonds.         United Kingdom Chart I-8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The UK trade and current account balance is deteriorating again, on the back of a more tumultuous post-Brexit transition. This has nudged the basic balance into negative territory (Chart I-8). The strong rally in the pound has also chiselled away some of the competitive edge British goods commanded on a global landscape. Significant foreign direct investment will be necessary to prevent the pound from adjusting much lower. There is progress, as the Conservative government has signed some significant trade deals over the course of the year. This should assuage foreign investor concerns over the potential for market access, should they invest in UK production. Portfolio investment in the UK has rolled over, but this is likely to be temporary if global equity markets remain resilient. Real rates are also improving in the UK, which should stem bond outflows. The key for the pound in the coming years will be productivity improvements which will allow foreign investors to keep financing the trade deficit.         Canada Chart I-9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments The Canadian basic balance has modestly improved, after being flat for over a decade. The improvement has been in the current account and is specifically driven by income receipts from Canada’s improving net international investment position (Chart I-9). Foreign direct investment has also remained resilient, and should remain so, given strong commodity prices. Canada is one of the largest exporters of crude oil, meaning the increase in petroleum prices will buffet the trade balance. In fact, since the 2020 lows, the monthly trade balance has recovered from almost negative C$6 billion to C$0.6 billion in April. Today, the basic balance stands at a surplus of 1% of GDP and should continue to improve.                   Australia Chart I-10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia sports the best improvement in both its trade and current account balance over the last few years. This has pushed the basic balance near a record 3.75% of GDP (Chart I-10). Australia’s long affair with a current account deficit is over. Investment in projects in the resource space are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. Australia’s comparative advantage in exports of LNG will likely be the next key driver of the trade balance, replacing coal shipments. This is consistent with the ESG megatrend. Net portfolio investment has been falling for years, but this just reflects Australia’s rising savings. In other words, the current account surplus is being recycled abroad. In short, the Aussie dollar has a large amount of running room, albeit, barring a tactical correction.             New Zealand Chart I-11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments The New Zealand basic balance has been negative for many years, only recently going into balance (Chart I-11). The boom in agricultural prices has helped boost the trade balance into surplus, but this has not been sufficient to bring the current account into balance. Coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities have keep the current account in structural deficit. Portfolio investments are accelerating out of New Zealand. The last time they hit -8% of GDP was just after the financial crisis. It is not clear why foreign investors are shunning this rather defensive market, but high valuations may be playing a key role. Importantly, FDI inflows remain steady, near 1.75% of GDP. Going forward, New Zealand should continue to see modest improvement in its basic balance, especially relative to the US, supporting the kiwi.           Switzerland Chart I-12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland has had a structural uptrend in its trade balance for decades (Chart I-12). This has buffeted both the current account and the basic balance. It has also allowed the trade-weighted Swiss franc to outperform on a structural basis. In Q1, the current account surplus rose to CHF 16 billion, a 60% increase from Q1 2020, driven by an improvement in the goods trade balance. However, both primary and secondary income were a drag on the current account balance. The net international investment position also improved on the back of a net increase in foreign asset purchases. However, a strong dollar in Q1 reduced the net value of foreign currencies in the portfolio. The positive balance-of-payment backdrop continues to create a headache for the Swiss National Bank. CHF has been weak this year, and the SNB will likely continue to intervene in the foreign exchange markets to calm future appreciation in the franc. That said, we expect the trade-weighted franc to rise on a structural basis.          Norway Chart I-13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Norway’s trade balance was heavily hit by the COVID-19 crisis but is slowly recovering (Chart I-13). The trade surplus started to plunge sharply due to falling energy prices at the beginning of the lockdown. Going forward, the reopening of the global economy, especially Europe, will benefit Norwegian exports of oil and gas. Meanwhile, tepid investment in global oil and gas extraction over the past five years will ensure Norway’s terms of trade remains robust. This will especially be the case thanks to growing production from the new Johan Sverdrup field. From a more fundamental perspective, the krone will also benefit from positive income flows. Norway has one of the biggest NIIPs in the world, which generates large income receipts that skew heavily toward equity dividends. This characteristic strengthens the bond between the NOK and global equities, making it the perfect procyclical currency. On a structural basis, 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.   Sweden Chart I-14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish current account balance has improved smartly in the last few quarters, boosting the basic balance to a surplus of over 5% of GDP. While the trade surplus has certainly improved, the primary income surplus has been the key driver (Chart I-14). FDI inflows have not had a strong impact on the basic balance. In terms of portfolio investment, this has turned negative as Riksbank purchases have crowded out investors. Income receipts have also needed to be recycled. In conclusion, the Swedish krona remains one of our favorite currencies due to its increasing basic balance surplus and its cheap valuation. We were stopped out of our long Nordic basket trade (NOK and SEK) against both the euro and the US dollar but will be looking to re-establish at more attractive levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) Three Key Views On Track (So Far) Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals China's Communist Party Centenary Goals China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Iran's Oil Production Will Return Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 13BGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 17Go Long Large Caps And Defensives Go Long Large Caps And Defensives Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan Territory: GeoRisk Indicator Taiwan Territory: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator

Highlights Entering 2H21, oil and metals' price volatility will rise as inventories are drawn down to cover physical supply deficits brought about by the re-opening of major economies ex-China. As demand increases and oil and metals supply become more inelastic, forward curves will backwardate further.  This will weaken commodity-price correlations with the USD and boost commodity-index returns. Going into next week's OPEC 2.0 meeting, the Kingdom of Saudi Arabia (KSA) and Russia likely will hold off on further production increases, until greater clarity around US-Iran negotiations and the return of Iran as a bona fide exporter is available. Chinese authorities will release 100k MT of copper, aluminum and zinc into tight domestic markets in July.  A two-day rally followed the news. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, following the ~ 230% move in crude oil and the ~ 100% rise copper prices.  Higher volatility will present buying opportunities for these ETFs  (Chart of the Week). We remain long commodity index exposure – S&P GSCI and COMT ETF – expecting steeper backwardations. We will go long the PICK ETF at tonight's close again, after being stopped out last week with a 23.9% return. Feature Heading into 2H21, industrial commodity markets will continue to tighten.  In the case of oil, this is caused by OPEC 2.0's production-management strategy – i.e., keeping supply below demand – and capital discipline among producers in the price-taking cohort.1 Base metals, on the other hand, are tightening because demand is recovering much faster than supply.2 Re-opening of major economies will boost refined-product demand in oil markets – e.g., gasoline and jet fuel – which will leave refiners little choice but to continue drawing on inventories to cover supply shortfalls in the near term (Chart 2). Chart of the WeekResources ETFs Follow Prices Higher Resources ETFs Follow Prices Higher Resources ETFs Follow Prices Higher Chart 2Refiners Will Continue Drawing Crude Investments Refiners Will Continue Drawing Crude Investments Refiners Will Continue Drawing Crude Investments Base metals – particularly copper and aluminum – will remain well bid in the face of constrained supply and higher consumption ex-China.  Despite China's widely anticipated decision to release strategic stockpiles of copper, aluminum and zinc next month into a tight domestic market – which we flagged last month – continued inventory draws will be required to cover physical deficits in these markets, particularly in copper (Chart 3).3 Chart 3Copper Inventories Will Draw As Demand Ex-China Rises Copper Inventories Will Draw As Demand Ex-China Rises Copper Inventories Will Draw As Demand Ex-China Rises Chart 4Steeper Backwardation, Higher Volatility Oil, Metals Vol Creates Buying Opportunities Oil, Metals Vol Creates Buying Opportunities Higher Vol On The Way As demand for industrial commodities increases and inventories continue to draw, forward curves will become more backwardated – i.e., material delivered promptly (next day or next week) will command a higher price than commodities delivered next month or next year: Consumers value current supply above deferred supply, and producers and merchants have to charge more to cover inventory replacement costs, which increase when prompt demand outstrips supply. The steepening of forward curves for industrial commodities will lead to higher price volatility in oil and metals markets, particularly copper: Demand will confront increasingly inelastic supply.  In this evolution, prices will be forced to allocate inelastic supply as demand increases.  Sometimes-sharp changes in price are required to equilibrate available supply with demand when this happens.  This can be seen clearly in oil markets, but it holds true for all storable commodities (Chart 4).4 Investment Implications Industrial commodity markets are entering a more volatile phase, which will be characterized by sharp price movements up and down over the short term, as demand continues to outpace supply. Our analysis suggests this is the beginning of a more volatile phase in industrial commodity markets.  The balance of risk in industrial commodity prices will remain to the upside as volatility increases. In the short term, fundamental imbalances can be addressed over a relatively short months-long horizon – i.e., OPEC 2.0 can release spare capacity over a 3-4 month interval to accommodate rising demand – so that price increases do not destroy demand as oil-exporters are rebuilding their fiscal balance sheets. Base metals markets will have a tougher time in the short run finding the supply to meet surging demand, but it can be done over the next year or so without prices getting to the point where demand-destruction sets in. Over the medium to long term, investor-owned oil and gas producers literally are being directed by policymakers, shareholders and courts toward an extended wind-down of production and investment in future production.  Markets have been pricing through just such a situation in the post-COVID-19 world, with OPEC 2.0 managing supply against falling demand and still managing to reduce inventories significantly.  If the world follows the IEA's pathway to a decarbonized future – in which no investment in new oil or gas production is required after 2025 – this will become the status quo for these markets going forward.5 Metals producers, on the other hand, are being encouraged to increase marketable supply at a rapid pace to accommodate demand driven by the build-out of renewable energy – chiefly wind and solar – and the grids that will be required to move this energy. Producers, however, remain reluctant to do so, fearing their capex investment to build out supply will produce physical surpluses that depress returns, similar to the last China-led commodity super-cycle. Supplying the necessary base metals to make this happen will be difficult at best, according to Ivan Glasenberg, CEO at Glencore.  At this week's Qatar Economic Forum, he said copper supply will have to double between now and 2050 to meet expected demand for this critical metal.  “Today, the world consumes 30 million tonnes of copper per year and by the year 2050, following this trajectory, we’ve got to produce 60 million tonnes of copper per year,” he said.  “If you look at the historical past 10 years, we’ve only added 500,000 tonnes per year … Do we have the projects? I don’t think so. I think it will be extremely difficult.”6 The volatility we are expecting in oil, gas and base metals prices, will present buy-the-dip opportunities in related equities vehicles.  Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, matching the ~ 230% move in crude oil and the ~ 100% rise in copper prices.  We remain long commodity index exposure – S&P GSCI, which is up 5.9% and the COMT ETF, which is up 7.6% – expecting steeper backwardations.  The trailing stop on our MSCI Global Metals & Mining Producers ETF (PICK) position recommended 10 December 2020 was elected, which stopped us out with a gain of 23.9%.  We are getting long the PICK again at tonight's close.   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 Commercial crude oil stocks in the US (ex-SPR barrels) fell 7.6mm barrels w/w in the week ended 18 June 2021, according to the US EIA. Including products, US crude and product inventories were down 5.8mm barrels. US domestic crude oil production was down 100k b/d, ending the week at 11.1mm b/d. Overall product supplied, the EIA's proxy for refined-product demand, was up 180k b/d at 20.75mm b/d, which is 129k b/d below 2019 demand for the same period. At 9.44mm b/d, gasoline demand was just below comparable 2019 consumption of 9.47mm b/d, while jet-fuel demand remains severely depressed vs. comparable 2019 consumption at 1.58mm b/d (vs. 1.92mm b/d).  Distillate demand (e.g., diesel fuel) for the week ended 18 June 2021 was 3.95mm b/d vs. 3.97mm b/d for the comparable 2019 period. Base Metals: Bullish Benchmark spot iron ore (62% Fe) prices are holding above $210/MT in trading this week, as demand for the steel input remains strong in China (Chart 5). The Chinese Communist Party (CCP) increased its level of intervention in the iron ore market this week, launching investigations into “malicious speculation,” vowing to “severely punish” anyone found to be engaged in such behavior, according to ft.com.7 Benchmark iron ore prices hit $230/MT in May. We continue to expect exports from Brazil to pick up in 2H21, which will push prices lower in 2H21. Precious Metals: Bullish In the aftermath of last Wednesday’s FOMC meeting gold prices lost nearly $86/oz (Chart 6). Our colleagues at BCA Research's USBS believe markets are paying too much attention to the Fed’s dot plots, and not to the central bank’s verbal guidance.8 Originally, the Fed stated that it will only start raising interest rates once a checklist of three conditions have been met. This checklist includes guidance on actual and expected inflation rates and the labor market. Gold prices did not react to Chair Powell's testimony before the House Select Subcommittee on the Coronavirus Crisis. Ags/Softs: Neutral US spring wheat prices are rallying on the back of dry weather in the northern Plains, while forecasts for benign crop weather in the Midwest pressured soybeans lower this week, according to successfulfarming.com. Chart 5 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN Chart 6 US Dollar To Keep Gold Prices Well Bid US Dollar To Keep Gold Prices Well Bid     Footnotes 1     Please see our most recent oil price forecasts published last week in Balance Of Risks Tilts To Higher Oil Prices.  It is available at ces.bcaresearch.com. 2     Please see A Perfect Energy Storm On The Way published on June 3, 2021 for further discussion. 3    Please see Less Metal, More Jawboning published on May 27, 2021, which flagged China's likely decision to release strategic stockpiles of base metals. 4    Chart 4 shows implied volatility as a function of the slope of the forward curve, i.e., the difference between the 1st- and 13th-nearby futures divided by the 1st-nearby future vs implied volatilities for Brent and WTI options.  This modeling extends Kogan et al (2009), mapping realized volatilities calculated using historical settlements of crude oil futures against the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009), "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64:3, pp. 1345-1375. 5    Please see fn 2's discussion of the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector beginning on p. 5 under The Case For A Carbon Tax. 6    Please see Copper supply needs to double by 2050, Glencore CEO says published on June 23, 2021 by reuters.com.  Of course, being a copper producer with large-scale base-metals projects due to come on line in the next year or so, Mr. Glasenberg could be talking his book, but as Chart 3 shows, copper has been and likely will be in physical deficits for years. 7     Please see China cracks down on iron ore market, published by ft.com on June 21, 2021. 8    Please see How To Re-Shape The Yield Curve Without Really Trying, published on June 22, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights The sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity demand and prices through the remainder of 2021. Commodity demand shocks dominate commodity supply shocks. Commodity supply shocks play only a transient role in setting prices. Go underweight basic resources equities versus the market. Commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar. Fractal trade: Short corn versus wheat. Feature Chart of the WeekDeclining Chinese Lending Is A Headwind For Metal Prices Declining Chinese Lending Is A Headwind For Metal Prices Declining Chinese Lending Is A Headwind For Metal Prices The recent collapse in China’s credit impulse has caught a lot of people’s attention, ours included. The collapse in the credit impulse quantifies the change in lending. Importantly, this means that even if the lending numbers themselves are large, the impulse will collapse if those lending numbers are declining – which is precisely what has happened in China. In the past year, China’s broad money supply has expanded by $17 trillion yuan, signifying a large amount of lending in the $100 trillion yuan economy. All well and good, except that the $17 trillion yuan has declined from an even larger $21 trillion yuan a year ago. To the extent that loans fund the demand for something, the $4 trillion yuan decline in those loans means that the demand for the something also declines. In the case of China, the something is the demand for industrial commodities, especially industrial metals (Chart of the Week). Using total social financing rather than the broad money supply reveals a similar downtrend in lending, and therefore a similarly collapsed impulse (Chart I-2 and Chart I-3) But as we explain in the next section, our preference is to focus on China’s broad money supply. Chart I-2Chinese Lending Is ##br##Declining... Chinese Lending Is Declining... Chinese Lending Is Declining... Chart I-3...So The 12-Month Credit Impulse Has Collapsed ...So The 12-Month Credit Impulse Has Collapsed ...So The 12-Month Credit Impulse Has Collapsed   Declining Chinese Lending Is A Headwind For Metal Demand When interpreting the lending numbers in any economy, there are four important things to keep in mind. First, we should focus on bank lending. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody’s spending power goes down. In contrast, when somebody borrows by issuing a bond, it just reallocates spending power from one person to another. The bond issuer sees his bank account and spending power go up, but the bond buyer sees his bank account and spending power go symmetrically down. Demand will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, and as already mentioned, the impact on economic demand comes from the change in lending – which is to say the credit impulse. This is just to compare apples with apples. Remember that GDP, demand, and lending are all flow statistics. Meaning that the change in demand depends on the change in lending (and not from absolute lending itself).1  Third, the most important part of lending is bank lending to the non-financial sector.2  This is because not all loans generate economic activity. Bank-to-bank lending and reserves held at the central bank stay trapped in the financial system. The money supply – which is on the liabilities side of the banks’ balance sheet – might not pick up this distinction. It could be expanding rapidly due to a surge in bank-to-bank lending and/or in reserves, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending – which is on the assets side of the banks’ balance sheet – and only count lending that is likely to generate economic activity. However, this logic only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. Total social financing includes most, but not all, shadow lending. Yet all shadow lending must eventually show up in the money supply. For this reason, in analysing Chinese lending, we prefer to focus on the broad money supply. Having said that, the messages coming from both the broad money supply and total social financing concur. Chinese lending is slowing. Chinese lending is slowing.  Fourth, we should choose the periodicity of the analysis to maximize its predictive power. This will depend on the specific lead times between the lending and the demand that it is funding, which will be discovered empirically. We find that the 1-year change in China’s broad money supply provides an excellent 1-year lead on industrial metal prices, because the lending leads commodity demand. The obvious rejoinder is, what about tight supply? The answer, from a recent academic paper – Drivers of commodity price booms and busts in the long run – is that for (non-oil) commodities, demand dominates supply. Specifically, “aggregate commodity and commodity-specific demand shocks appear to strongly dominate commodity supply shocks in driving variation in real commodity prices… commodity supply shocks play a rather secondary and transient role.”3 On this basis, we conclude that the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021 (Chart I-4 and Chart I-5). Chart I-4Declining Chinese Lending Is A Headwind For Industrial Metals... Declining Chinese Lending Is A Headwind For Industrial Metals... Declining Chinese Lending Is A Headwind For Industrial Metals... Chart I-5...And Iron Ore ##br##Prices ...And Iron Ore Prices ...And Iron Ore Prices   Chinese Lending Is An Investment ‘Super-Driver’ We are strong believers in investment reductionism. Our reductionist philosophy stems from two guiding principles: Occam’s Razor – which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle – which says that 80% of effects come from just 20% of causes.4 Investment banks hate investment reductionism. Given that they want to sell you as much product as possible, they make investment seem much more complicated than it is. Yet most of the moves in most financial markets result from a very small number of ‘super-drivers.’ Our objective is to un-complicate investment – to identify the super-drivers, and to call them right. Clearly, one super-driver right now is the evolution of the pandemic, and specifically the evolution of new variants of the virus, as we discussed in Viral Variants Strike Down The Reflation Trade. A second super-driver is the direction of the T-bond yield, because this drives the direction of many other market trends such as growth versus value, defensives versus cyclicals, and US versus Europe. As we discussed in Don’t Panic About US Inflation, the T-bond yield is likely to drift lower in the coming months. Today’s report identifies a third super-driver – the evolution of Chinese lending. To repeat, the sharp drop in Chinese lending over the past year is highly likely to weigh on (non-oil) commodity prices through the remainder of 2021.   The sharp drop in Chinese lending over the past year is highly likely to weigh on commodity prices through the remainder of 2021. This means that basic resources equities are likely to underperform both in absolute terms, and relative to the broader market (Chart I-6 and Chart I-7). On a 6-month horizon, go underweight basic resources versus the market. Chart I-6Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Declining Chinese Lending Is A Headwind For Basic Resources Equities, Both In Absolute Terms... Chart I-7...And Relative To The Broad ##br##Market ...And Relative To The Broad Market ...And Relative To The Broad Market It also means that commodity currencies like the Canadian dollar and New Zealand dollar are likely to underperform versus the US dollar (Chart I-8 and Chart I-9). Chart I-8The Canadian Dollar Just Tracks Inflation Expectations The Canadian Dollar Just Tracks Inflation Expectations The Canadian Dollar Just Tracks Inflation Expectations Chart I-9The New Zealand Dollar Just Tracks Inflation Expectations The New Zealand Dollar Just Tracks Inflation Expectations The New Zealand Dollar Just Tracks Inflation Expectations Commodities Are Fractally Fragile Reinforcing the super-driver of a Chinese lending slowdown, the 260-day fractal structure of the commodity complex is at the same extreme of fragility that heralded turning-points in 2009, 2010, 2018, and 2020 (Chart I-10). Chart I-10The Fractal Structure Of The Commodity Complex Is Extremely Fragile The Fractal Structure Of The Commodity Complex Is Extremely Fragile The Fractal Structure Of The Commodity Complex Is Extremely Fragile As a reminder, a fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. At this point, as longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. Eventually though, when the longer-term investors re-enter the price setting process, the price snaps back towards the valuation anchor. A fragile fractal structure is a warning that the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. In early May, we highlighted this fragility in the commodity complex and, exactly as anticipated, most commodities then started to correct. We are trading the on-going correction in commodities through a short position in PKB as well as short CAD/USD, and both positions are now in healthy profit. Staying on the theme of commodities, the 60 percent outperformance of corn versus wheat over the past year is only starting to correct now (Chart I-11). Hence, a recommended trade is to short the corn future (number 2, yellow) versus the wheat future (number 2, soft red) setting the profit target and symmetrical stop-loss at 12 percent. Chart I-11The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct The 60 Percent Outperformance Of Corn Versus Wheat Will Soon Correct Finally, relating to a non-commodity position, we have extended by 33 days the holding period of short France versus Japan. Thus far, the position has traded sideways so we are giving it more time to move into profit. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The change in lending is the definition of the credit impulse. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Voxeu.org: Drivers of commodity price booms and busts in the long run, David Jacks and Martin Stuermer. 4 Often known as the 80-20 rule. In fact, it could be 90-10, 95-5, or even 100-5 as the numbers do not have to add up to 100. 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