Currencies

Highlights The Indian rupee is about 7% cheaper than its fair value versus the US dollar. Expanding capital expenditures will boost India’s productivity and raise returns on capital. That will attract higher capital inflows, propelling the rupee. India also has a better inflation outlook compared to the US because of the government’s prudent fiscal policy and muted wage pressures. Foreign bond investors should stay overweight India in an EM local currency bond portfolio. Equity investors should upgrade India from neutral to overweight in view of receding pandemic-related disruptions. Feature The outlook for the Indian rupee over the medium term (six months to three years) is positive. In this report we will identify the two primary drivers of the rupee/US dollar exchange rate over this time horizon. The first is the relative purchasing power in the two economies. The second is return on capital; more specifically, relative return on capital in the two countries. Both indicate that the rupee will likely benefit from a tailwind over the next few years. The robust currency outlook also supports our bullish view on Indian local currency bonds versus their EM peers and US Treasuries. In this report, we will explain how this context, and the Indian market’s own idiosyncrasies, warrants favoring Indian bonds in a global fixed-income portfolio. Finally, we are upgrading Indian stocks back to overweight in an EM equity portfolio. Relative Purchasing Power Chart 1The Indian Rupee Is Below Its Fair Value The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value The concept of “purchasing power parity (PPP)” theorizes that the currency of an economy with higher inflation will adjust lower (i.e., depreciate) relative to the currency of an economy that has lower inflation. The upshot is that the relative inflation dynamics of the two countries could provide insight into their exchange rate outlook.   The top panel of Chart 1 shows that the rupee is currently cheap when measured against what would be its “fair value”. The latter has been derived from a regression analysis between the manufacturers’ relative producer prices of the two countries and the exchange rate. Notably, a deviation from the fair value has also been a good predictor of where the nominal exchange rate will head in the years to come. Whenever the rupee appeared cheap relative to its fair value, it tended to appreciate over the next few years. The opposite has also been true. The current deviation from the fair value implies that the rupee could appreciate by 7% in the coming years (Chart 1, bottom panel). A deeper look into the inflation dynamics reveals that almost all significant directional moves in the rupee-dollar exchange rate over the past 25 years can be explained by movements in the relative inflation differential between the two economies. The rupee typically depreciates versus the dollar when Indian inflation is rising relative to that of the US; and appreciates when the relative inflation is falling. The only times they briefly diverged were during or in the immediate aftermath of a crisis, such as the global financial crisis or the COVID-19 pandemic. However, they were quick to return to their long-term correlations. Relative Inflation Outlook Going forward, the relative inflation outlook favors the rupee. This is because the fiscal and monetary policies in India will likely be tighter in India than in the US for the foreseeable future. Incidentally, India’s core inflation has fallen significantly relative to that of the US in the past decade (Chart 2). India’s inflation is driven mainly by two factors. The first is food prices; more specifically, the “minimum support price” that the Indian government pays to the farmers to procure food grains. Since the government is by far the single largest purchaser, the price it pays usually sets the floor in the market. The ebbs and flows of this procurement price have had a telling impact on the country’s inflation over the past few decades (Chart 3, top panel). Chart 2India's Inflation Has Fallen Significantly In The Past Decade The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 3Notwithstanding The Temporary Pandemic-Era Surge In Fiscal Spending … The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   In recent years, however, the authorities have been careful and did not hike the procurement prices over much. That has helped to keep headline CPI in check. Further, the government legislated new farm laws last year, which will usher in private capital in the agriculture sector. This will help improve farm productivity and keep food prices under control1 in the future.  Chart 4...Fiscal Policy Has Been Very Prudent Since The GFC The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value The other driver of Indian inflation is fiscal expenditure. The rise and fall in government spending leads core inflation by about a year (Chart 3, bottom panel). Notably, even though fiscal spending has swelled over the past year to provide relief to a pandemic-stricken economy, this one-off surge is offset by collapse in output and demand. Besides, the odds are high that the government will revert to a tighter stance as soon as the pandemic is brought under control. Indeed, such a fiscal splurge represents a departure rather than a fixture in India’s fiscal policy. Ever since the global financial crisis, successive Indian governments adopted a rather prudent fiscal stance. Chart 4 shows that fiscal spending steadily declined from 17% of GDP in 2009 to 12% by 2019. The conservative stance was implemented by both the previous UPA government and the current NDA government which came to power in 2014. Such a stance not only helped to substantially reduce the country’s fiscal and primary deficits but was also instrumental to the steady decline in inflationary pressures. The wage pressures in the economy are also rather muted. In rural areas, both farm and non-farm wages have been growing at a slow pace and have often remained below consumer inflation for the past six years (Chart 5, top panel). A similar picture is seen in the central banks’ (RBI) industrial outlook surveys. The assessment for salary and remuneration shows a subdued outlook; in fact, the indicator is below zero (Chart 5, bottom panel). This implies that wage pressures in the industrial sector have also been very low since 2017. Going forward, as tens of millions of young people continue to join the work force every year, the broader picture is unlikely to change. Overall, subdued wage pressures will also keep a tab on general inflation in the economy. Relative Return On Capital The other important driver of the rupee versus the dollar over the medium term is the direction of Indian companies’ return on capital relative to those of the US. When the return on capital rises, especially relative to that of the US, foreign capital flows into India in search of higher profits. Those capital inflows help boost the rupee. Chart 6 shows that over the past 25 years the rupee strengthened versus the dollar during those periods when return on assets of Indian non-financial corporates rose. The rupee depreciated when this ratio dropped. Chart 5Inflation Outlook Remains Sanguine As Wage Pressures Are Muted The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 6Rupee Strengthens When Relative Return On Capital In India Rises... The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   The same holds true when Indian firms’ return on assets are compared relative to those of the US. All major moves in rupee strength and weakness largely coincided with the relative rise and fall in return on assets (Chart 6, bottom panel). Chart 7...As Foreign Capital Inflows Into India Boosts The Rupee The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Thus, relative profitability clearly has a major influence on the exchange rate. And as alluded to earlier, the link is via capital inflows. The ebbs and flows of capital into India have a very explicit impact on the rupee (Chart 7). Going forward, a pertinent question is in which way will India’s return on capital be headed. Our bias is that, beyond the pandemic-related disruptions, it is heading higher over the medium term. We have the following observations: A sustainable rise in return on capital is highly contingent on productivity gains. And the latter depends on capital investment in new plants, machinery, technology, as well as on infrastructure. Thus, a meaningful and sustained rise in capital expenditures could be a harbinger of higher returns in the future. Firms, on their part, would engage in new capital expenditures once they are sanguine of future demand as well as profits. Notably, both gross and net profits of India’s non-financial sector have rebounded rather strongly. Capital expenditure has recovered in tandem (Chart 8). The latter indicates that companies do not consider profit recovery a fluke and are confident demand will remain upbeat. Corroborating the above, imports of capital goods have skyrocketed. This is also a precursor to higher capex down the road (Chart 9). Chart 8Rebounding Profits Have Encouraged Firms To Resume Capex... The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 9...As Evidenced In Accelerating Capital Goods Imports The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 10Capital Goods Imports Have Been Rising For The Past Several Years The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Markedly, India’s import profile has been encouraging in recent years. The share of capital goods in total imports and non-oil imports have been rising (Chart 10). This indicates that firms have not been averse to capital expenditure. This also shows that unlike in some other EM countries, imported consumer goods did not overwhelm India’s capital goods imports. The last time India saw a surge in capital goods imports was in the 2000s, a period when the country’s capex and profits also surged. That period coincided with a multi-year bull run in the rupee and stocks. The early 2010s, on the other hand, saw a deceleration in capex and capital goods imports – and was followed by a period of sub-par return on capital. Now, the tides are turning again. Finally, the quality of capital inflows has also improved over the past decade. India has been receiving ever higher amounts of FDI compared to portfolio inflows (Chart 11). The former is a much more efficient form of capital and are also more likely to boost capital expenditures enhancing productivity in the economy. Incidentally, India’s real gross fixed capital formation has hovered between 30% and 35% of GDP since 2008 – easily the highest rate globally, save China (Chart 12). Hence, if a new capex cycle ensues, which seems likely, it will happen over and above the base built over the past decades. That should help drive labor productivity and profits up by a notch. Chart 11...Along With Steady Growth In FDI The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 12A New Capex Cycle On Top Of The Previous Base Will Boost Productivity The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   All in all, odds are that Indian productivity will improve going forward, which in turn will boost firms’ profitability metrics. That should help propel the rupee. Bond Bullish The combination of a stable currency, prudent fiscal policy, and a benign inflation outlook make Indian bonds highly desirable to foreign investors. Notably, thanks to some systemic factors, Indian bonds are not as sensitive to bouts of fiscal profligacy and/or inflation in India: Over the past 20 years or so, ten-year bond yields hovered in a rather narrow band of 6%- 9%. A crucial reason for that stability is very limited foreign holdings: only about 2% of Indian government bonds are held by foreign investors. This has reduced yield volatility substantially. In many EM countries, where foreign holdings are much higher, a negative growth shock usually leads to both rising bond yields and a depreciating currency – which perpetuate each other – as foreign investors head for the exit. In the case of India, a negative shock is tempered by falling bond yields, as domestic investors switch from riskier assets to government bonds. Not only are the foreign holdings in India too small to push up yields but the falling yields also encourage them to stay invested. That explains why bond yields in India fell during each of the crises: in 2008-09, 2014-15 and more recently in 2020. A second reason is the existence of captive domestic bond investors: commercial banks. As per the Reserve Bank of India mandate, all banks in India are obligated to hold a certain percentage (currently 18%) of their total deposits in government securities (called Statutory Liquidity Ratio, or SLR). These mandatory holdings have also helped reduce yield volatility. The impact of the above factors can often be seen at play. For one, a surge in India’s fiscal expenditure does not necessarily cause a spike in bond yields. This is because, devoid of any fear of dumping by foreign bond holders, India can and does ramp up government spending when growth is very weak. Those are the times when domestic investors shed riskier assets and move to the safety of government bonds. Hence, we see accelerating fiscal spending coinciding with low and falling bond yields, unlike in many other EM countries (Chart 13, top panel).   For a similar reason, a surge in India’s fiscal deficit does not necessarily cause a spike in bond yields either. If anything, widening budget deficits usually coincide with falling bond yields; and shrinking deficits with rising bond yields (Chart 13, bottom panel).  The explanation for this apparent anomaly is as follows: periods of stronger growth bring in more fiscal revenues and thus reduce the deficit. But strong growth and rising inflationary pressures also lead to higher interest rate expectations reflected in higher bond yields. The opposite happens when growth slows. Even though fiscal deficit goes up as revenues drop, decelerating inflationary pressures pave the way for lower bond yields. A pertinent question here is, given the idiosyncrasies of Indian bond markets, what then drives Indian bond yields? The simple answer is the business cycle. This is why rising bond yields coincide with stronger bank credit growth and falling yields with weaker credit growth (Chart 14). Chart 13A Surge In Fiscal Spending Or Deficits Doesn't Mean A Spike In Bond Yields The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 14The Business Cycle Is The Ultimate Driver Of Indian Bond Yields The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value   What is also notable is that the impact of any spike in consumer and/or producer price inflation on bond yields is not very pronounced (Chart 14, bottom panel). A crucial reason for that is again the SLR. Because of it, regardless of commercial banks’ own inflation expectations, they cannot dump government bonds. That puts a cap on bond yields even when inflation is rising. Besides, a rise in inflation usually coincides with accelerating bank credit and bank deposits. The latter causes higher demand for government bonds from banks (to maintain SLR). That in turn helps keep the bond yield lower than it otherwise would be. Chart 15The Spike In Public Debt Is Temporary, And Bond Investors Are Not Worried The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Bottom Line: The absence of foreign investors, the presence of large captive domestic investors and a long-held orthodox fiscal stance have turned the Indian bond market into a different ball game than many other EM local currency bond markets. One takeaway from this idiosyncrasy is that the current steep, but temporary, fiscal deficit should not be a matter of concern for bond investors. For a similar reason, the recent rise in the public debt-to-GDP ratio should have little impact on bond yields (Chart 15). Finally, a moderate rise in inflation is also unlikely to cause Indian bond yields to soar. Investment Conclusions The medium-term outlook for the Indian rupee is positive. It is also quite competitive, especially when compared to the currencies of India’s major competitors vying for multinationals to establish their manufacturing capacity (Chart 16). This means the rupee has some room for nominal appreciation without hurting its competitiveness. Chart 16The Indian Rupee is Quite Competitive The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value This emphasizes our view that investors should continue to overweight India in an EM fixed-income portfolio. While strong growth and higher US bond yields can drive up Indian government bond yields, the former will also push up the rupee – as detailed in a previous section. The currency returns will offset any possible capital loss owing to rising yields, while a positive carry will boost total returns. Notably, because of the latter, a similar rise in yields (say, 100 basis points) in India and US bonds will have a much less negative impact on total return terms for Indian bonds than in the case of US Treasurys.  The long end of the Indian yield curve offers value: the 10-year bond yield is 200 basis points above the policy rate. The spread of India’s 5-year bond over that of the US is an impressive 550 basis points (Chart 17, top panel). Given the sanguine rupee outlook, odds are that Indian government bonds will continue to outpace US treasuries in total return terms – even when Indian growth accelerates and inflation rises modestly (Chart 18). Chart 17Indian Bonds Offer Value Relative To US And EM Counterparts The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Chart 18Higher Carry And A Stronger Currency Will Lead To Total Return Outperformance The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value When compared to the same-duration JP Morgan GBI-EM bond index, India offers a spread of 100 basis points. India has steadily outperformed that index in US dollar total return terms over the past several years (Chart 17, bottom panel). That is unlikely to change in future, thanks to the high carry and a relatively more stable currency. As such, investors should stay on with our recommendation of overweighting India in an EM local currency bond portfolio (Chart 18). Chart 19Go Overweight Indian Stocks In An EM Equity Portfolio The Rupee Has A Tailwind, And Bonds Offer Good Value The Rupee Has A Tailwind, And Bonds Offer Good Value Several factors that make the outlook for the rupee positive also argue for a positive outlook for Indian stocks. Like most other EM currencies, the rupee is pro-cyclical, and it tends to move with Indian share prices. Notably, Indian stocks have broken out of their previous highs (Chart 19). On a separate note, as the number of daily COVID-19 cases in the country have subsided, so have the chances of debilitating lockdowns. As such, economic activity is slated to gather steam. We had tactically downgraded India from overweight to neutral in an EM equity portfolio on April 22 in view of skyrocketing COVID-19 cases and deaths back then. Even though the pandemic situation had deteriorated considerably after our downgrade, share prices have staged a nice rebound to our surprise. It’s time to upgrade this bourse back to overweight (Chart 19, bottom panel). Investors should also stick with our sectoral recommendation of long Indian Banks and short EM banks. As we elaborated in our report on Indian banks, a recovery in the business and capex cycles would be very positive for Indian private sector banks (that make up 90% of the MSCI India Banks index) – given that they have aggressively cleansed their balance sheets of NPLs and have thereby already taken the hit in their earnings. Fixed-income investors should close the trade of receiving 10-year swap rates in India. We had recommended it along with other EM local rates back in April 2020 as a play on lower interest rates in EM. India’s 10-year swap rates have risen by 166 basis points since then. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 For more details see our report India’s Reform Drive: How Momentous (Part 1) dated 19 November 2020.

Highlights Tactically downgrade cyclical equities from overweight in Europe. The shift in global growth drivers, the beginning of the global liquidity withdrawal, and lingering COVID worries create headwinds for the cyclicals-to-defensives ratio this summer. Weaker global inflation expectations, commodity prices, and a dollar rebound will accompany this period of turbulence. The relative technical and valuation backdrop will also contribute to this period. Short consumer discretionary / long telecommunication is a high-octane version of the trade. Short technology / long healthcare is its lower-risk / lower-reward cousin. This temporary portfolio shift is a risk management move to capitalize on our positive 18- to 24- month view on cyclicals. Feature Last week, we recommended investors adopt a more defensive tactical posture.  They should raise cash and shift into defensive quality names in order to weather a summer replete with potential downside risk. This will place investors in a good position to shift back into a more aggressive stance this fall, when cyclical sectors should resume their outperformance. This week, we explore this idea in more detail. The combination of a Chinese credit slowdown, a potential transition in the driver of growth away from goods into services, and a shift in tone from global central banks will feed the expected market volatility this summer. European defensive stocks are set to outperform during this period. Buying telecommunication equities / selling consumer discretionary stocks is a high octane bet on this trend, while going long healthcare / short technology shares is its low-risk incarnation. Summer Storms This summer, three forces will feed some downside risk in the market and, more specifically, an underperformance of cyclical sectors relative to defensive ones: a transition in global growth, preliminary signs that global central banks will begin to take away the punch bowl, and disappointments caused by COVID variants. Growth Transition The global economy is set to cool down as we transition away from the first stage of the post-pandemic recovery. As we showed last week, China’s deteriorating credit impulse is consistent with global industrial activity receding from its extremely robust pace of expansion (Chart 1). The continued decline in China’s banking system excess reserve ratio suggests that total social financing flows will slow further. Consequently, China’s intake of raw materials and industrial goods will decelerate, which will impact global industrial activity negatively. Already, the New Orders component of China’s Manufacturing PMI has rolled over. The disappointment of Chinese retail sales last week further indicates that China will act as a drag on global growth in the coming quarters. We have also highlighted that the combined effect of higher yields and oil prices has become strong enough to alter negatively the path of global industrial activity going forward. Our Global Growth Tax indicator, which includes both variables, shows that the US ISM Manufacturing survey and the global manufacturing PMI have reached their apex and will moderate this summer (Chart 2). Chart 1The China Drag The China Drag The China Drag Chart 2Rising Costs Bite Rising Costs Bite Rising Costs Bite The problem for global growth is one of changing leadership. Global economic activity is not about to collapse, but the extraordinary surge in goods consumption that started in 2020 will make room for a catch-up in the service sector. As an example, US retail sales stand 15% above their pre-pandemic trends; however, services spending still lies 7% below its pre-pandemic tendency (Chart 3). Thus, as summer progresses, the recent deceleration in consumer spending on goods will continue and services will progressively pick up the slack. The change in growth leadership will cause some temporary trepidation in global economic activity, because it is happening when the effect of both the Chinese credit slowdown and the previous increase in yields and oil will be most potent. As a result, we expect the G-10 Economic Surprises Index to follow that of China and experience an air pocket this summer (Chart 4). Chart 3From Goods To Services From Goods To Services From Goods To Services Chart 4Where China Goes, So Will The G-10 Where China Goes, So Will The G-10 Where China Goes, So Will The G-10   The Chaperone Is On The Way More than 65 years ago, former Fed Chair William McChesney Martin noted that the job of central bankers was to be “the chaperone who has ordered the punch bowl removed just as the party was really warming up.” Chart 5The Chaperone Is Waking Up The Chaperone Is Waking Up The Chaperone Is Waking Up Today, the party is a rager, and central bankers are indicating that they will remove the punch bowl soon. Real estate speculation is worrying the Bank of Canada, and its balance sheet has already shrunk by C$99 billion, to C$476 billion. The Norges Bank has indicted that it will lift interest rates twice this year. The Reserve Bank of New Zealand is set to lift the Official Cash Rate soon. The Bank of England has begun to adjust its asset purchases and could begin a full-fledge tapering this year. The 800-pound gorilla is the Fed, which telegraphed more clearly last week its intention to raise rates twice in 2023, and therefore moved closer to the pricing of the OIS curve (Chart 5). Implied in this forecast, the Fed will start tapering its asset purchase in early 2022 at the latest. This change in tone by global central banks is not a major problem for the business cycle – global rates are still far below any reasonable estimates of the neutral rate of interest, but periods of transition in monetary policy are often associated with transitory market turbulences. This time will not be an exception, especially because it is happening when global growth is downshifting. Delta, Gamma, Epsilon, etc? Chart 6Depressed Macro Volatility Depressed Macro Volatility Depressed Macro Volatility With the rapid progress of vaccination, the worst of the COVID tragedy is behind us. Nonetheless, the pandemic is not yet fully in the rear-view mirror, not even in the Western nations that lead the global inoculation campaign. SARS-CoV-2 continues to evolve and will therefore produce new variants over time, some of which will be problematic. The UK illustrates this phenomenon. The government has postponed the so-called Freedom Day, when life returns to normal, by five weeks despite the country’s high vaccination rate. The Delta variant is significantly increasing among the unvaccinated and not fully inoculated Britons. Many countries will also face this problem. These delays will be minor and will not threaten national recoveries. However, they will feed market tensions in a context where global macro volatility is low (Chart 6), global growth is already peaking, and monetary accommodation is receding. Global Market Implications… The confluence of the change in global economic growth leadership, the upcoming liquidity removal, and the potential for short-lived delays to the global economic re-opening point toward a decline in global inflation expectations, a rebound in the US dollar, weaker commodity prices, and an underperformance of global cyclical relative to defensive equities. Over the coming months, inflation breakeven rates are likely to soften, while real yields will rise modestly. In May, US inflation breakeven rates peaked near 2.6%, their highest level in ten years. A weaker global growth impulse in combination with a Fed that is more willing to remove some monetary accommodation will cool inflationary fears among investors and cause inflation expectations to decline further. However, the specter of tighter policy will also support TIPS yields. Bond yields are likely to correct somewhat more over the summer. Bond prices have not yet fully purged their oversold conditions (Chart 7); thus, a decrease in inflation expectations will temporarily support Treasury prices, even if real yields do not fall. Recent market action is moving in this direction. Last week, by Thursday evening, 10-year Treasury yields had already lost their 9 bps rise that followed Wednesday’s FOMC meeting. 30-year Treasury yields have plunged to a four-month low. Bund yields are unable to hang on to their gains either. The dollar has more upside this summer. Higher real US yields offer a potent backing for a DXY that still refuses to drop below 89. Moreover, the greenback is a highly counter-cyclical currency and is particularly sensitive to the gyrations in the global industrial cycle. Thus, the deceleration in the global manufacturing cycle will create a temporary tailwind for the greenback. Over the past three years, the gap between US TIPS yields and the Chinese Economic Surprise index explained the fluctuation of the DXY; it currently points toward a continued rebound in the USD (Chart 8). Even if this move is ephemeral, it will have implications for investors this summer. Chart 7Technical Backdrop For Bonds Technical Backdrop For Bonds Technical Backdrop For Bonds Chart 8Near-Term Upside For The DXY Near-Term Upside For The DXY Near-Term Upside For The DXY Commodities will also suffer. Natural resource prices have rallied in a parabolic fashion and our Composite Technical Indicator is massively overbought (Chart 9). Meanwhile, Chinese authorities are verbally jawboning industrial metal prices and have begun to release copper, zinc, aluminum, and nickel from their stockpiles. In this context, the Chinese credit slowdown and the imminent removal of monetary accommodation in various corners of the globe will catalyze a correction in commodities, even if a new supercycle has begun. The recent travails of lumber prices, which have collapsed 47% since May 7 (while they still remain in technical bull market!), may constitute a canary in the coalmine for the wider commodity complex. Global cyclical equities have greater downside against their defensive counterparts. US markets are global trendsetters; while the S&P cyclicals have lost some altitude compared to defensives, they have yet to purge their oversold state and remain very expensive (Chart 10). This backdrop makes them vulnerable to slowing Chinese import growth, a stronger dollar, and weaker commodity prices. Chart 9Will The GSCI Follow Lumber? Will The GSCI Follow Lumber? Will The GSCI Follow Lumber? Chart 10Vulnerable Global Cyclicals Vulnerable Global Cyclicals Vulnerable Global Cyclicals   … And European Investment Implications Chart 11European Cyclicals Are Also At Risk European Cyclicals Are Also At Risk European Cyclicals Are Also At Risk The European cyclicals-to-defensives ratio is vulnerable, like it is in the US. Hence, a more defensive portfolio bias makes sense for the summer, which should allow investors to regain maximum cyclical exposure later this year. Short consumer discretionary / long telecommunications and short technology / long healthcare are pair trades with particularly attractive risk profiles. The cyclicals-to-defensives ratio is technically unattractive. The relative share prices stand toward the top of their 16-year trading range (Chart 11). Moreover, their 52-week momentum measure is rolling over at a highly elevated level, while the 13-week rate of change is deteriorating. Meanwhile, the Combined Mechanical Valuation Indicator1 (CMVI) of the cyclicals towers far above that of the defensives and is consistent with a corrective episode (Chart 11, bottom panel). The drivers of the performance of Eurozone cyclical relative to defensive sectors confirm that cyclicals could suffer a turbulent summer. For instance: The potential for further declines in global yields does not bode well for the European cyclicals-to-defensives ratio (Chart 12). Weaknesses in market-based inflation expectations would prove particularly threatening (Chart 12, bottom panel). The deceleration in China’s total social financing flows anticipates an underperformance of European cyclicals (Chart 13). As China’s credit decelerates, so will the earnings revisions of cyclical equities. Moreover, a weaker Chinese TSF is consistent with falling Treasury yields. Chart 12Lower Inflation Expectations Equals Underperforming Cyclicals Lower Inflation Expectations Equals Underperforming Cyclicals Lower Inflation Expectations Equals Underperforming Cyclicals Chart 13Cyclicals Listen To China Cyclicals Listen To China Cyclicals Listen To China The potential for weaker commodity prices is another problem for European cyclical equities (Chart 14). Commodities capture the ebb and flow of global growth sentiment, which is also a driver of the earnings revisions of cyclicals relative to defensives. Moreover, commodity prices greatly affect the earnings of cyclical equities. Unsurprisingly, the momentum of the European cyclicals-to-defensives ratio correlates closely with the BCA Commodity Composite Technical Indicator (Chart 14, bottom panel). Cyclicals perform poorly when the dollar appreciates. The Eurozone’s cyclicals-to-defensives ratio moves in lock-step with the euro and high-beta cyclical currencies (Chart 15). These relationships reflect the counter-cyclicality of the dollar, as well as the negative effect on global financial conditions of its rallies, and thus, on the earnings outlook for cyclicals. Chart 14Beware The Impact Of Weaker Commodities Beware The Impact Of Weaker Commodities Beware The Impact Of Weaker Commodities Chart 15A Strong Dollar Hurts European Cyclicals A Strong Dollar Hurts European Cyclicals A Strong Dollar Hurts European Cyclicals Chart 16Short Consumer Discretionary And Long Telecommunication Short Consumer Discretionary And Long Telecommunication Short Consumer Discretionary And Long Telecommunication Based on these observations, we are tactically downgrading cyclicals from our overweight stance for the summer, despite our conviction that cyclicals have upside on an 18- to 24-month basis. We look at this move as risk management. For investors looking to bet on a potential underperformance of cyclical equities in Europe, we recommend two positions: a high-octane pair trade and a lower-risk one. The high-octane version is to sell consumer discretionary stocks and buy telecommunications ones (Chart 16). This pair trade is exposed to lower yields, lower inflation expectations, and the shift in growth drivers from China and goods consumption to services expenditures. Additionally, the relative 52-week momentum measure is overextended, while the 13-week rate of change is already sagging. The CMVI of the consumer discretionary sector is extremely elevated, while that of telecommunication stocks is the most depressed of any Eurozone sector. Consequently, the gap between the two sectors’ CMVI stands at nearly three-sigma, which is concerning because the RoE of consumer discretionary shares lies 7% below that of the telecoms industry (Chart 16, third and fourth panel). Because higher RoEs should justify higher valuations, consumer discretionary and telecommunication stand out as the greatest outliers among European sectors (Chart 17). As an added benefit, this trade enjoys a positive dividend carry of more than 2.5%. Chart 17Spot The Outliers Summertime Blues Summertime Blues Chart 18Short Technology And Long Healthcare Short Technology And Long Healthcare Short Technology And Long Healthcare The low octane pair trade is to sell technology stocks and buy healthcare names instead. This position offers lower expected returns but also a lower risk, because both sectors are growth stocks and they will benefit from falling yields and inflation expectations. However, based on their respective CMVI, tech equities are much more expensive than healthcare ones (Chart 18), while they are also extremely overbought. Thus, healthcare should benefit more from falling yields and inflation expectations than tech. Moreover, technology is a more cyclical sector than healthcare; it will therefore be more sensitive to the evolution of global growth. Bottom Line: We remain positive on the outlook for cyclical equities on an 18- to 24-month horizon, but the changing global growth leadership, the imminent removal of global monetary accommodation, and the demanding valuation and technical backdrop of the European cyclicals-to-defensives ratio suggest that a period of turbulence will materialize this summer. Thus, we are tactically downgrading cyclicals. Investors should consider going long telecommunications / short consumer discretionary as a high-octane tactical bet on this portfolio stance. Buying healthcare / selling technology would constitute a lower risk / lower return play. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Footnotes 1 For a detailed explanation of the Combined Mechanical Valuation Indicator, see Special Report, “Valuation – A Mechanical Approach,” dated May 31, 2021. Currency Performance Summertime Blues Summertime Blues Fixed Income Performance Government Bonds Summertime Blues Summertime Blues Corporate Bonds Summertime Blues Summertime Blues Equity Performance Major Stock Indices Summertime Blues Summertime Blues Geographic Performance Summertime Blues Summertime Blues Sector Performance Summertime Blues Summertime Blues

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 3China Catching Up To Cuba On Basic Wellbeing China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 4China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 5BChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues China's Rise Continues China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Highlights The yen is the most underappreciated currency in developed markets today. Our bullish thesis on the yen rests on a simple pillar: Japan will successfully overcome the pandemic like its Western counterparts. This good news is not yet reflected in the price of the yen or Japanese assets. The Japanese economy is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for any equity market or currency. Remain short USD/JPY. The biggest risk to our view is a big rebound in US Treasury yields that catalyzes outflows from Japan and bids up the dollar. Feature The Japanese economy remains under siege from the pandemic. The number of new Covid-19 cases is at the highest level per capita in developed Asia (Chart I-1). As a result, the manufacturing PMI is the lowest in the region (and the developed world for that matter), even though global demand for goods is booming. As an industrial powerhouse very much dependent on external growth, this result has been both surprising, and a severe blow to the domestic recovery. A third wave of infections has also crippled the services sector, pinning its recovery well behind its global peers. The combination has led to an underperformance of both the Japanese currency and stock market (Chart I-2). Chart I-1Japan Is A Basket Case In Developed Asia Japan Is A Basket Case In Developed Asia Japan Is A Basket Case In Developed Asia Chart I-2The Japanese Recovery Has Lagged The Japanese Recover Has Lagged The Japanese Recover Has Lagged There are a variety of hypotheses for Japan’s anemic recovery. The initial government response to the pandemic was slow and botched, with a nationwide lockdown only implemented on April 16 last year, much later than other economies. The health response has also been disappointing – despite a high availability of hospital beds, only a small percentage were used to treat Covid-19 patients. As a matter of fact, only a fifth of Japan’s 8,000+ hospitals are public, which has slowed the pace of both treatments and more recently, vaccinations. This is dampening both business and consumer sentiment, crippling the recovery. In this report, we explore how fast and how soon Japan can emerge from crisis management mode. More importantly, with Japanese shares and the currency laggards in this recovery, has the stage been set for a coiled-spring rebound? Our bias is that most of the bad news may already be reflected in depressed asset prices, while an inevitable economic recovery is not. Mapping The Japanese Recovery The pace of vaccination is accelerating in Japan and should soon hit the critical 50%-60% threshold necessary to reach herd immunity (Chart I-3). Shipments of the vaccine have been increasing since May, with 100 million Pfizer doses, and 40 million Moderna shots expected by the end of June. According to government officials, Japan aims to secure enough doses to inoculate its entire population by the end of September. Chart I-3AAn Accelerating Pace Of Vaccinations In Japan An Accelerating Pace Of Vaccinations In Japan An Accelerating Pace Of Vaccinations In Japan Chart I-3BCurrency Returns Have Roughly Tracked Vaccination Progress The Case For Japan The Case For Japan A turnaround in the vaccination campaign would not only boost public opinion about the Covid-19 response but would also be a welcome fillip to much subdued consumer and business sentiment. Economic surprises in Japan have flipped from being the most disappointing in the developed world to the most robust. Expectation surveys are also pointing to rising optimism about future growth (Chart I-4). It should only be a matter of time for hard data to follow suit. The first catalyst for a recovery will come from consumption, particularly around the Olympics. While foreign spectators will not be allowed in Japan, athletes, organizers and sponsors should jumpstart the pickup in inbound tourism. At the peak in 2019, tourist arrivals were almost 25% of the entire Japanese population, compared to almost zero today (Chart I-5). Chart I-4Green Shoots In Japan Green Shoots In Japan Green Shoots In Japan Chart I-5Nowhere To Go But Up Nowhere To Go But Up Nowhere To Go But Up More importantly, a pickup in tourism will also coincide with improvement in labor market conditions. Real wages are accelerating at the fastest pace in a decade. This is boosting household spending, as the unemployment rate declines. Should a recovery trigger less need for precautionary savings, this will further boost consumption (Chart I-6). It is important to note that significant headwinds to Japanese consumption are now abating. The consumption tax hike in 2019 delivered a severe punch to aggregate demand. COVID-19 eventually dealt a near-fatal blow. The silver lining is that those two shocks have led to a massive build in pent-up demand, which should be unleashed in the coming quarters. Government outlays have also gone a long way towards boosting aggregate demand during the pandemic. A new budget to be compiled in October or November should help ease the fiscal drag in 2022 (Chart I-7). The fiscal multiplier tends to be much larger in a liquidity trap, so it will be important for the government to resist the urge to rein in spending amidst a surging debt profile. Chart I-6A Recovery In ##br##Consumption A Recovery In Consumption A Recovery In Consumption Chart I-7The Fiscal Thrust In 2022 Could Be Less Negative The Fiscal Thrust In 2022 Could Be Less Negative The Fiscal Thrust In 2022 Could Be Less Negative Our bias is that a vigorous rebound in Japanese consumption, as was witnessed in other developed economies, could jumpstart the economic recovery. The Risk Of A China Slowdown A boom in external demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows. In our view, this risk should be monitored, but is likely overstated. First, while 23% of Japanese sales go to China, other developed and emerging markets account for the lion’s share of exports. For example, exports to the US account for 18% of sales while EU exports account for 9%. One of the most cyclical components of Japanese exports is machine tool orders, which continue to inflect higher. If Chinese growth does indeed slow, it accounts for large but not overwhelming 30% of overall orders (Chart I-8).  From a much broader perspective, rising infrastructure spending and an economic recovery around the world should continue to buffer foreign machinery orders and demand for Japanese goods, keeping industrial production humming (Chart I-9). Chart I-8A Boom In Foreign Demand A Boom In Foreign Demand A Boom In Foreign Demand Chart I-9A Renewed Industrial Cycle A Renewed Industrial Cycle A Renewed Industrial Cycle Japanese Growth, Inflation And The Yen The best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Like most other economies, Japan saw the worst private-sector contraction in decades. For an economy whose interest rates have lingered near zero since the 1990s, this is not good news. However, whenever the structural growth rate of the Japanese economy (proxied as private-sector GDP) has begun to recover from very low levels (and even before), the trade-weighted yen has staged powerful rallies (Chart I-10). Chart I-10The Yen And Japanese Growth The Yen And Japanese Growth The Yen And Japanese Growth Part of the reason is that any Japanese growth improvement is likely to be non-inflationary. Most developed economies are seeing both realized or expected inflation at or exceeding their central bank’s targets. This is not the case in Japan (Chart I-11). This means that real rates should remain quite elevated, a positive for the currency. The three key variables the authorities pay attention to for inflation, core CPI, the GDP deflator and the output gap, are low and falling (Chart I-12). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population. This means that generating inflation is a more arduous task than in other developed economies. Meanwhile, with almost 50% of the Japanese consumption basket in tradeable goods, domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Chart I-11Higher Real Rates In Japan Higher Real Rates In Japan Higher Real Rates In Japan Chart I-122% = Mission Impossible? 2% = Mission Impossible? 2% = Mission Impossible?   Real rates are likely to stay positive in Japan for the foreseeable future. For one, there is not much the BoJ can do in terms of easing policy. The central bank already owns 50% of outstanding JGBs, and about 89% of ETFs. As such, the supply side puts a serious limitation on how much more stimulus the BoJ can provide (Chart I-13). Chart I-13Stealth Tapering By The BoJ? Stealth Tapering By The BoJ? Stealth Tapering By The BoJ? Meanwhile, the most potent policy for the Bank of Japan is to keep Japanese rates low as global yields are rising. This is because yield curve control will incrementally lower the appeal of higher Japanese real yields. We expect that in an environment where global inflationary pressures are normalizing (3-6 months), this is much less of a risk. The Yen In The Current Global Context Foreigners have a huge sway on the performance of Japanese assets, especially equities. Foreign holders account for near 30% of the Japanese equity float (Chart I-14). The size of day-to-day flows could be much bigger. As such, a call on the yen is also predicated on substantial inflows from foreign buying. The yen and the Japanese equity market have historically been negatively correlated. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but true underlying productivity gains (Chart I-15). On this note, the return on equity of Japanese shares has overtaken that of the euro area, even though they still trade at a price-to-book discount to their European counterparts. This could result in less yen hedging by foreign investors, which would restore a positive relationship between the relative share price performance and the currency. Chart I-14Large Foreign Participation In Japanese Stocks Large Foreign Participation In Japanese Stocks Large Foreign Participation In Japanese Stocks Chart I-15A Breakdown In ##br##Correlation? A Breakdown In Correlation? A Breakdown In Correlation?   As a counter-cyclical currency, the yen usually weakens against other developed market currencies when global growth picks up. However, this is less likely in an environment where global yields remain anchored at low levels. Real interest rates are already higher in Japan, and any improvement in Japanese growth will revive talks about normalization from the BoJ. Even if the BoJ eventually stands pat, the starting point is extremely short positioning by speculators, which could trigger a potent short squeeze (Chart I-16). Chart I-16Dollar Weakness = Yen Strength (Usually) Dollar Weakness = Yen Strength (Usually) Dollar Weakness = Yen Strength (Usually) Finally, the yen rises versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. As such as a low-beta currency, the yen could weaken on its crosses, but still rise versus the dollar. Stay short USD/JPY. FX Trading Model We regularly update our FX trading model as a mechanical check on what could otherwise be subjective currency biases. Fortunately, our model agrees with us for the month of June, with recommendations to short the US dollar, mostly against the yen (Chart I-17). For risk management purposes, we are also tightening stops on our short AUD/MXN, and long Scandinavian currency basket positions to protect profits. Chart I-17ATrading Model Is Bullish Yen Trading Model Is Bullish Yen Trading Model Is Bullish Yen Chart I-17BTrading Model Is Bearish NZD Trading Model Is Bearish NZD Trading Model Is Bearish NZD   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The recent data out of the US have been robust: The May employment report showed an increase of 559K jobs, versus expectations of a 650K increase. The unemployment rate declined from 6.1% to 5.8% in May.  The Jolts job opening survey showed an increase from 8.3mn to 9.3mn. CPI came in at 5% year on year in May, outpacing expectations of a 4.7% rise. Month on month, CPI grew by 0.6% in May, above the 0.4% consensus. Core CPI came in at 3.8% year on year in May, beating the expected 3.4%. The US dollar DXY index was down 0.4% this week. The broad theme in FX markets has been a normalization in US yields, despite a strong CPI report and an otherwise robust jobs report. This suggests market participants are already positioned for an upside surprise in US data. We are agnostic towards the US dollar in the next 1-3 months but will use any bounce as a selling opportunity. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area remain upbeat: The euro Sentix confidence index bounced from 21 to 28.1 in June. Both employment and GDP growth in the first quarter were better than expectations. The ECB kept monetary policy on hold but upgraded its economic forecasts for both 2021 and 2022. The euro was up 0.4% this week. While the focus on the euro has been on the possibility of the ECB tapering asset purchases, the biggest driver of the currency has been relative growth. We expect eurozone GDP to continue inflecting higher, in line with the ECB’s revised forecasts. This is bullish the euro. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan was robust: Average cash earnings rose 1.6% year on year in April. Overtime pay rose by 6.4%. The GDP report was revised upward, with year on year growth at -3.9% for the first quarter, compared to a previous assessment of -4.8%. The Eco Watchers Survey for May came in at 38.1, with the outlook component actually rising. Machine tool orders are inflecting higher, rising 141% year on year in May. The yen was up by 0.8% against the USD this week. The yen is the most underappreciated currency in developed markets today. Our bullish thesis on the yen rests on a simple pillar: Japan will successfully overcome the pandemic like its Western counterparts. This good news is not yet reflected in the price of the yen or Japanese assets. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data out of UK have been solid: Halifax house prices are rising almost 10% year on year as of May. The BRC retail sales monitor also remains robust at 18.5% year on year in May. The pound was up by 0.4% this week against the USD. Cable has already priced dividends from a fast vaccine rollout, and the positive impact on the domestic UK economy. As such, more pronounced GBP gains will need to stem from an improvement in UK productivity. We are bullish on GBP over the long-term based on valuation but will stand aside in the near term. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was scant data out of Australia this week: The AIG Services index rose from 61 to 61.2. While the NAB business confidence index edged lower from 23 to 20 in May, the survey component was more upbeat, rising from 32 to 37. The AUD was up by 1.3% this week against the USD. Price pressures remain weak in Australia and the vaccination progress continues to lag, even though it has been accelerating lately. This will keep the RBA dovish. This provides a small window to short the AUD, as other central banks turn more hawkish. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: ANZ busines confidence came in at -0.4% in Q1, versus 1.8% last quarter. Electronic card retail sales increased by 1.7% month on month in May after a 4.4% increase in April. The NZD was up by 0.7 % this week against the dollar. The biggest risk to the New Zealand economy is a self-reinforcing deflationary spiral from a currency that rallies too far, too fast. However, in a context of slowing Chinese growth, this is less likely. We are short the NZD against the CHF, as insurance should a riot point in markets develop. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data out of Canada have been as expected: Canada lost 68K jobs in May, but this was mostly tied to the lockdowns. Losses were concentrated to part-time employment. The unemployment rate did rise from 8.1% to 8.2%. The May Ivey PMI rose from 60.6 to 64.7. The Canadian trade balance improved from -C$1.4bn to a surplus of C$0.6bn in April. The Bank of Canada kept policy on hold this week, both in terms of interest rates and asset purchases. The CAD was flat against USD this week. Most of the normalization by the BoC has already been priced in the OIS curve, which is denting any near-term policy impact on the CAD. In our view, near term catalysts for the exchange rate will stem from what happens to crude oil prices as well as the Canadian recovery, as the world economy reopens. On this front, we remain bullish. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The was scant data out of Switzerland this week: The unemployment rate fell to 3% in May, from 3.2%. CPI came in at 0.6% in May, double the rate of the previous month. The Swiss franc was up by 1% this week against the USD. The franc currently sits in a “heads I win, tails I do not lose too much” juncture. It is cheap with a real effective exchange rate that is at one standard deviation below fair value. As such, should the pickup in global trade continue, this will buffet the franc. That said, the franc also benefits from bouts of volatility as a safe-haven currency. On this basis, we are long CHF/NZD as contrarian play. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The was scant data out of Norway this week: Core CPI came in at 2.7% in May, lower than the previous month. PPI growth registered a 29.4% increase in April, year on year. The NOK was up by 1.3% this week against the dollar, the best performing G10 currency. Our special report on the NOK last week pointed to many catalysts that should keep the currency an outperformer in the coming quarters. We remain short both USD/NOK and EUR/NOK and are tightening stops this week to protect profits.  Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been positive: The current account surplus rose from SEK 69.8bn to SEK 78.3bn in Q1. Industrial production came in at 26.4% year on year in April. CPI came in at 1.8% year on year and 0.2% month on month in May, in line with expectations. CPIF registered at 2.1% year on year and 0.2% month on month increase in May, both below the consensus. The SEK was up by 1.2% this week against the USD. Sweden stands to be one of the economies that benefits most from a renewed industrial cycle. This is by virtue of its export orientation and huge industrial concentration compared other economies. Meanwhile, the SEK remains one of the cheapest currencies in our models. We are short both EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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

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