Fiscal

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

Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields An Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering European Growth Is Recovering European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Inoculation Acceleration In Europe Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Warning Signs For European Export Demand Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Chart 10NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms ECB Easing Takes Many Forms ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary European Bond Strategy Summary European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ECB Outlook: Walking On Eggshells ECB Outlook: Walking On Eggshells Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Inflation Rears Its Head Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Equity Market Trembles Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save China's Rising Propensity To Save China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … China's Fiscal-And-Credit Impulse Falls Sharply... China's Fiscal-And-Credit Impulse Falls Sharply... Chart 6B… As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks China Reflation Trades Near Peaks China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus China Verges On Overtightening China Verges On Overtightening Chart 9Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China Verges On Overtightening China Verges On Overtightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China China Verges On Overtightening China Verges On Overtightening Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s China Verges On Overtightening China Verges On Overtightening The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal China Verges On Overtightening China Verges On Overtightening Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 China Verges On Overtightening China Verges On Overtightening The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Stick To Long India / Short China Stick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com

Highlights Over the 2021-22 period, renewable capacity will account for 90% of global electricity-generation additions, per the IEA's latest forecast. This will follow the 45% surge (y/y) in renewable generation capacity added last year, which occurred despite the COVID-19 pandemic (Chart of the Week). Continued investment in renewables and EVs – along with a global economic rebound – are pushing forecasts at banks and trading companies to a $13k - $20k/MT range for copper, vs. ~ $10.6k/Mt (~ $4.80/lb) at present. Should these stronger metals forecasts prove out, investments that extend low-carbon use of fossil fuels via carbon-capture and circular-use technologies will become more attractive. Investment in these technologies has been limited because there is no explicit global reference price to assess investments against. A carbon market or tax would provide such a bogey and accelerate investment. It could be monitored via a Carbon Market Club, which would limit trade to states posting and collecting the tax.1 Feature At almost 280GW, renewable energy capacity additions last year increased 45% y/y, the most since 1999, according to the IEA's most recent update on renewable energy.2 For this year and next, renewables are expected to account for 90% of capacity additions, led by solar PV investment increasing ~ 50% to 162GW. Wind capacity grew 90% last year, increasing to 114GW, and is expected to increase ~ 50% to end-2022. As renewables generation – and EV investment – continues to grow, demand for bulks (steel and iron ore) and base metals, led by copper, will pull prices higher. This is occurring against a backdrop of flat supply growth and physical deficits over the four years ended 2020 (Chart 2). According to the IEA, a 40% increase in steel and copper prices over the September 2020 to March 2021 period played a role in higher solar PV module prices. Chart of the WeekRenewables Capacity Surges Surging Metals Prices And The Case For Carbon-Capture Surging Metals Prices And The Case For Carbon-Capture The supply side of the copper market will remain in deficit this year and next, in our assessment, and may continue on that trajectory if, as Wood Mackenzie expects, demand grows at a 2% p.a. rate over the next 20 years and miners remain reluctant to commit to the capex required to keep up with demand.3 Chart 2Physical Deficits Will Draw Copper Stocks... Physical Deficits Will Draw Copper Stocks... Physical Deficits Will Draw Copper Stocks... ESG risk for copper – and other metals required to build the generation and infrastructure required in the renewables buildout – will increase as prices rise, which also will add to cost.4 Cost increases coupled with increasing ESG risks in this buildout will increase the attractiveness of carbon-capture and circular-economy technology investment, in our view. This would extend the use of low-carbon fossil fuels if the technology can move the world closer to a net-zero carbon future. However, unless and until policy catalyzes this investment, – e.g., via a global carbon trading price or tax – investment in these technologies likely will continue to languish. Carbon-Capture Tech's Unfulfilled Promise The history of Carbon Capture, Utilization and Storage (CCUS) has been one of high hopes and unmet expectations. It is generally recognized as a route to mitigate climate change; however, its deployment has been slower than expected. Low-carbon technology requires more critical metals than its fossil-fuel counterpart (Chart 3). Apart from the issue of cost, the ESG risks of mining metals for the renewable energy transition will increase as more metals are demanded, which we discussed in previous research.5 According to Wood Mackenzie, mining companies will need to invest nearly $1.7 trillion in the next 15 years to help supply enough metals to transition to a low carbon world.6 Chart 3Low-Carbon Tech Is Metals Intensive Surging Metals Prices And The Case For Carbon-Capture Surging Metals Prices And The Case For Carbon-Capture Given these looming physical requirements for metals, fossil fuels most likely will need to be used for longer than markets currently anticipate, as a bridge to the low-carbon future, or as part of that future, depending on how successfully carbon is removed from the hydrocarbons used to power modern society. If so, using fossil fuels while mitigating their environmental impact will require highly focused technology to lower CO2 and other green-house gas (GHG) emissions during the transition to a low-carbon future. Enter CCUS technology: This technology traps CO2 from sources that use fossil fuels or biomass to make the energy required to run modern societies. In the current iterations of this technology, CO2 can either be compressed and transported, or stored in geological or oceanic reservoirs. This can then be used for Enhanced Oil Recovery (EOR) to extract harder-to-reach oil by injecting CO2 into the reservoirs holding the hydrocarbons.7 The Scope For CCUS Investment CCUS investment spending is increasing, as are the number of planned facilities using or demonstrating this technology. In the 2020 edition of its Energy Technology Perspectives, the IEA noted 30 new integrated CCUS facilities have been announced since 2017, mostly in advanced economies such as US and Europe, but also in some EM nations. As of 2020, projects at advanced stages of planning represented a total of $27  billion, more than double the investment planned in 2017 (Chart 4). Among its many goals, the Paris Agreement seeks a balance between emissions by man-made sources and removal by greenhouse gas (GHGs) sinks (absorption of the gases) in the second half of the 21st century. Practically, many countries – especially EM economies – will still need to use fossil fuels to develop during this period (Chart 5).8 Chart 4Carbon-Capture Projects To Date Surging Metals Prices And The Case For Carbon-Capture Surging Metals Prices And The Case For Carbon-Capture Chart 5EM Development Will Require Fossil-Fuel Energy Surging Metals Prices And The Case For Carbon-Capture Surging Metals Prices And The Case For Carbon-Capture CCUS In The Energy Sector As a fuel that emits fewer GHGs than coal – i.e., half the CO2 of coal – natural gas can be used effectively as a bridge to green-power generation (Chart 6). Chart 6Natural Gas Will Remain Attractive As A Bridge Fuel Surging Metals Prices And The Case For Carbon-Capture Surging Metals Prices And The Case For Carbon-Capture The CO2 in natgas needs to be removed before dry gas is sold as pipeline-quality gas or LNG. This CO2 is normally vented to the atmosphere; however, by using CCUS technology, it can be reinjected into geological formations and used for EOR. For this reason, LNG companies in the US, the world’s largest LNG exporter, have been looking into investing in CCUS technology in a bid to become greener.9 CCUS can also be used to produce low-cost hydrogen – so-called blue hydrogen – using natural gas and coal, as opposed to the more expensive electrolysis process, which uses renewables-based electricity to produce "green" hydrogen. The lower blue-hydrogen costs will make clean hydrogen more accessible to emerging nations, opening new avenues for the world to use the energy carrier in its decarbonization effort. The Value Of Ccus In Other Industries CCUS technology can be retrofitted to existing power and industrial plants, which, according to the IEA, could otherwise still emit 8 billion tons of CO2 in 2050, around one-quarter of annual energy-sector emissions in 2020. Of the fossil fuel generators, coal-fired power generation presents the biggest CO2 challenge, with most of the emissions coming from China and other EM Asia nations, where the average plant age is less than 20 years. Since the average age of a coal fired power plant is 40 years, according to the US National Association of Regulatory Commissioners, this implies that these plants have a long remaining life and could still be operating until 2050. CCUS is the only alternative to retiring or repurposing existing power and industrial plants. The IEA believes that CCUS is imperative to reach net-zero carbon emissions. In its Sustainable Development Scenario - in which global CO2 emissions from the energy sector decline to net-zero by 2070 – CCUS accounts for 15% of the cumulative reduction in emissions. If the world needs to reach net-zero by 2050 instead, it will need almost 50% more CCUS deployment.10 Properly implemented and scaled, CCUS can allow industries to continue using oil, gas and coal and to attain net-zero carbon emission targets, boosting demand for fossil fuels in the medium term. This is especially important to EM development. Why Aren’t We Further Along In CCUS? What Can Be Done? The main reason CCUS isn’t used more widely is because of its cost. Currently, the cost of capturing carbon varies, based on the amount of CO2 concentration, with Direct Air Capture being most expensive (Chart 7). Given the prohibitive costs, CCUS has not been commercially viable. However, the same argument could have been used against implementing renewable sources of energy. While at one point the Levelized Cost of Energy from renewable sources was high, as these sources have been scaled up – aided in no small part by government subsidies – costs have fallen, following something akin to a Moore’s Law cost-decay curve. A Levelized Cost of Energy for solar generation reported by Lazard Ltd., which allows for comparisons across technologies (e.g., fossil-fuel vs renewable), shows generation costs fell by 89% to $40/MWh from $359/MWh from 2009-2019 (Chart 8). This learning curve was able to take place because of government subsidies, which promoted the deployment of solar technology. Chart 7CCUS Can Be Expensive Surging Metals Prices And The Case For Carbon-Capture Surging Metals Prices And The Case For Carbon-Capture Chart 8Subsides Could Support CCUS, Just As Was Done For Solar Subsides Could Support CCUS, Just As Was Done For Solar Subsides Could Support CCUS, Just As Was Done For Solar The cost of CCUS technology is falling. For example, in 2019 the Global CCS Institute reported it cost $100/ton to capture carbon from the Canada-based Boundary Dam using a CCS unit built in 2014. The cost of carbon captured at the US-based Petra Nova plant – built three years later – using improved technology was $65/ton. Both are coal-powered electricity plants. The report also noted coal-fired power plants planning to commence operations in 2024-28 using the same CCS technology as those at Boundary Dam and Petra Nova expect carbon costs to be ~ $43/ton, due to steeper learning curves, research, lower capital costs due to economies of scale, and digitalization. One commonality amongst these sources of cost reductions is that companies need to invest more into CCUS and familiarize themselves with this technology. As was the case with renewables, government subsidies would reduce the prohibitive costs of operating CCUS technology, and draw more participation to refining this technology. Early, first-of-its-kind CCUS will be expensive, however subsidies in the form of capital support or tax credits will increase CCUS implementation and research. Boundary Dam and Petra Nova are examples of facilities that benefitted from government subsidies. The facilities received $170 million and $200 million respectively from Canadian and US Government agencies at the time of the CCS units’ construction. The US has also implemented a 45Q tax credit system which pays facilities $50/ton of CO2 stored and $35/ton of CO2 if it is used in applications like Enhanced Oil Recovery. According to the Global CCS Institute, in late-2019, of the eight new CCUS projects that were added in the US, four cited the presence of 45Q as the key driver. Putting Carbon Markets And Taxes To Work The EU’s Emissions Trading System (ETS) market, which was implemented in 2005, is an example of innovative policy which incentivizes companies to curb emissions, using market forces. The price of carbon measured in these markets puts a tangible value on a negative externality, which before this went unrecorded. The downside of this ETS is its reliance on the EU's environmental policy implementation, which is subject to policy changes that complicate supply-demand analysis for longer-term planning – e.g., the recent increase in its emissions target to a minimum of 55% net reduction in GHG emissions by 2030. An alternative to policy-driven trading of emissions rights is a per-ton tax on emissions, which governments would impose and collect. This would raise costs of technologies using fossil fuels – including those used in the mining industry to increase supply of critical bulks and base metals needed for the renewables transition. At the same time, such a tax would give firms supplying and using technologies that raise CO2 levels an incentive to lower CO2 output using CCUS technologies. ETS markets and governments imposing CO2 taxes could form Carbon Market Clubs – a technology developed by William Nordhaus, the 2018 Nobel Laureate in Economics – that restrict trading to states that can demonstrate their participation and support of actual carbon-reduction detailed in the Paris Agreement via trading or tax schemes.11 As the green energy transition gains traction and governments implement more net-zero emissions policies, the price of carbon will rise. As the price of carbon rises, the price tag associated with companies’ carbon emissions will increase with it. With market participants expecting the price of carbon to continue to rise after hitting record values, the incentive for companies operating in the EU to use CCUS technology will rise, as would the incentive for firms facing a carbon tax.12 Bottom Line: Given the meteoric price rise of green metals, underfunded capex, and the ESG risks associated with mining metals for the low carbon future, we expect fossil fuels to play a larger role in the transition to a low-carbon society than markets are currently expecting. For countries to be able to use fossil fuels while ensuring they achieve their climate goals, the use of CCUS technology is important. To increase CCUS uptake, governments will need to subsidize this technology until demand for it gains traction, just like in the case of renewables. Encouraging ETS and carbon-tax schemes also will be required to catalyze action.   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 Brent prices were knocking against the $70/bbl door going to press, following the IEA's assessment of a robust demand recovery in 2H21 (Chart 9). The IEA took its 1H21 demand growth down 270k b/d, owing to COVID-19-induced demand destruction in India, OECD Americas and Europe, but left its 2H21 estimate intact, making overall demand growth for this year 5.4mm b/d. The EIA also expects 5.4mm b/d demand growth for this year, and growth of 3.7mm b/d next year. OPEC left its full-year 2021 demand growth estimate at 6mm b/d. OPEC 2.0 meets again on June 1 and will look to return more of its sidelined production to the market, in our estimation. We will be updating our supply-demand balances and price forecasts in next week's report. Base Metals: Bullish Spot copper prices traded on either side of $4.80/lb on the CME/COMEX market this week as we went to press. Threats of a tax increase in Chile, where a bill calling for such a measure is making its way through Congress; a potential strike by mine workers; and a shortage of sulfuric acid used in the extraction of ore brought about, according to Bloomberg, by reduced global sulfur supplies due to lower refinery runs during the pandemic all are keeping copper well bid. Our target for Dec21 COMEX copper remains $5/lb (~ $11k/ton on the LME). We remain long calendar 2022 COMEX copper vs short 2023 COMEX copper expecting physical supply deficits to continue to force storage draws, which will backwardate the metal's forward curve. Precious Metals: Bullish US CPI data on Wednesday showed that headline inflation rose by 4.2% for the month of April compared to the previous year. While this increase is the highest since 2008, this jump could also be fueled by a low base effect – Inflation levels were falling this time last year as the pandemic picked up. While rising prices increases demand for gold as an inflation hedge, if the Federal Reserve increases interest rates on the back of this data, the US dollar will rise, negatively affecting gold prices (Chart 10). However, we do not expect the Fed to abruptly change its guidance on this report, and therefore expect the central bank will treat this blip as transitory. As of yesterday’s close, COMEX gold was trading at $1,835.9/oz. Ags/Softs: Neutral Going to press, the Chicago soybean market was surging ahead of the scheduled World Agriculture Supply and Demand Estimates (WASDE) report due out later Wednesday. Front-month beans were trading ~ $16.70/bu, up 2% on the day. This month's WASDE will contain the USDA's first estimate for demand in ag markets for the 2021/22 crop year. Markets are expecting supplies to tighten as demand strengthens. Chart 9 Brent Prices Going Up Brent Prices Going Up Chart 10 Covid Uncertainty Could Push Up Gold Demand Covid Uncertainty Could Push Up Gold Demand   Footnotes 1     Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016.  The intellectual and computational framework for such technology was developed by William Nordhaus, the 2018 Nobel Laureate in Economics. 2     Please see Renewable Energy Market Update, Outlook for 2021 and 2022.pdf, published by the IEA this week. 3    WoodMac notes, "without additional substantial investment, production will decline from 2024 onwards. Coupled with demand growth, this decline in output will lead to a theoretical shortfall of around 16 Mt by 2040."  The consultancy estimates an additional $325 - $500+ billion will be needed to meet copper demand over this period.  Please see Will a lack of supply growth come back to bite the copper industry? Published 23 March 2021 by woodmac.com. 4    Please see Renewables ESG Risks Grow With Demand, which we published 29 April 2021.  It is available at ces.bcaresearch.com. 5    Refer to footnote 4. 6    Please see Low carbon world needs $1.7 trillion in mining investment, published by Reuters. 7     This method is used to increase oil production. It changes the properties of the hydrocarbons, restores formation pressure and enhances oil displacement in the reservoir. Using EOR, oil companies can recover 30% to 60% of the original oil level in the reservoir.  Please see Enhanced Oil Recovery published by the US Department of Energy. 8    Please see the Reuter’s column CO2 emission limits and economic development. 9    Please see World Oil’s U.S. LNG players tout carbon capture in bid to boost green image. 10   Please see IEA’s Special Report on Carbon Capture Utilisation and Storage, published as a part of the Energy   Technology Perspective 2020.  11    See footnote 1 above. 12    Please see Cost of polluting in EU soars as carbon price hits record €50 by the Financial Times. 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

Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis.  Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Climbing Swiss Peaks Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone A Good Sign For The Eurozone A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Sweden Leads The Eurozone Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Accelerating Vaccinations Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus A Surprising Dance A Surprising Dance Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Ample European Pent-up Demand Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises Decomposing The Surprises Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns A Surprising Dance A Surprising Dance The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks A Surprising Dance A Surprising Dance Table 3A Bullish Backdrop For EUR/USD A Surprising Dance A Surprising Dance The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Rising German Yields? Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9).  Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February.  The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth Support For Household Net Worth Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More UK Consumption Will Rise More UK Consumption Will Rise More Chart 12Accelerating UK Inflation Accelerating UK Inflation Accelerating UK Inflation   Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains.  It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Deteriorating Profit Performance Deteriorating Profit Performance Chart 16Quite The Valuation Premium Quite The Valuation Premium Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead Lower EUR/GBP Ahead Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Currency Performance A Surprising Dance A Surprising Dance Fixed Income Performance Government Bonds A Surprising Dance A Surprising Dance Corporate Bonds A Surprising Dance A Surprising Dance Equity Performance Major Stock Indices A Surprising Dance A Surprising Dance Geographic Performance A Surprising Dance A Surprising Dance Sector Performance A Surprising Dance A Surprising Dance ​​​​​​​ Closed Trades

Highlights The Scottish parliamentary election does not present a near-term risk of a second referendum on Scottish independence. Independence is possible down the road but very unlikely due to a host of economic and geopolitical challenges still relevant in the twenty-first century. Book gains on long CHF-GBP. Go long FTSE 100 versus developed markets excluding the United States. Feature British equities have underperformed developed markets over the past decade – even if we exclude the market-leading United States (Chart 1). The British equity market is heavily concentrated in cyclical sectors like financials and materials and has a low concentration in information technology and communications services. As such the bourse has sprung to life since the advent of the COVID-19 vaccine and the prospect of a government-stimulated global growth recovery. In keeping with our strategic preference for value over growth we also look constructively at British equities. A potential source of geopolitical and political risk is Britain’s ongoing constitutional crisis, which flared up with the failed Scottish independence referendum in 2014 and the successful referendum to leave the EU in 2016. Tensions within the UK and between the UK and EU are part of the same problem – a loss of popular confidence and trust in the current nation-state and governing institutions in the aftermath of hyper-globalization.1 This constitutional crisis added insult to injury for UK stocks by jacking up policy uncertainty and undermining the attractiveness of domestic-oriented UK companies that suffered from trade disruptions with the European Union. Chart 1UK Referendums Added Insult To Injury UK Referendums Added Insult To Injury UK Referendums Added Insult To Injury Chart 2Post-Brexit Trading Range For GBP-EUR Post-Brexit Trading Range For GBP-EUR Post-Brexit Trading Range For GBP-EUR Now the COVID-19 pandemic and its aftermath have changed the global scene entirely and Brexit is no longer Britain’s chief concern. But there is still a lingering question over Scotland’s status. The Scottish question has recently weighed on the British pound and reinforced the new trading range for the GBP-EUR exchange rate in the aftermath of a “hard” exit from the European Union (Chart 2). Scotland voted for a new parliament on May 6 and the preliminary results are coming in as we go to press. The pro-independence Scottish National Party is still the most popular party and even if it falls short of a majority, as online betting markets expect, it has pro-independence allies with which it could form a coalition (Chart 3). Its leader, Scottish First Minister Nicola Sturgeon, has promised to pursue a second popular referendum on seceding from the United Kingdom by 2023. Chart 3Betting Markets Doubt Single-Party Majority For SNP United Kingdom Stays United United Kingdom Stays United British Prime Minister Boris Johnson, backed by a strong Conservative Party parliamentary majority, has vowed not to allow a second referendum, arguing that the 2014 plebiscite was supposed to lay the question to rest for a while. Scottish opinion in favor of secession stands at 43.6% today, right near the 44.7% that nationalists achieved in 2014 (Chart 4). Chart 4Support For Independence Ticks Down, Still Shy Of Majority United Kingdom Stays United United Kingdom Stays United Our takeaway is to fade the Scottish risk. Book gains on our long CHF-GBP tactical trade. Go long British equities relative to DM-ex-US on the expectation of global economic normalization, which is beneficially for the outwardly oriented British multinationals that dominate the British bourse. Does Scotland Have Grand Strategy? The history of Scotland is marked by internal differences that prevent it from achieving unity and independence. Even in the twenty-first century, when many factors have coalesced to make Scottish independence more likely than at any time since the eighteenth century, the 2014 referendum produced a 10% gap in favor of remaining in the United Kingdom. This majority is all the more compelling when viewed from the perspective of geography because cross-regional support for the union is clear (Map 1). Map 1Scottish Independence Referendum Result, 2014 United Kingdom Stays United United Kingdom Stays United Why is Scotland always divided? Because it is trapped by the sea and adjacent to a greater power, England. England is usually strong enough to keep Scotland from consolidating power and asserting control over its maritime and land borders. Specifically, Scotland contains a small population (at 5.5 million today) and small economic base (GBP 155 billion in economic output at the end of 2022) dispersed over an inconvenient geography. The low-lying plains around the Firth of Forth that form the historic core of Scotland share a porous border with England. The highlands provide a retreat for Scottish forces during times of conflict, which makes it extremely difficult for southern forces, whether Roman or Anglo-Saxon, to conquer Scotland. But the highlands are equally hard for any standalone Scottish state to rule. Meanwhile the western isles are even more remote from the seat of Scottish power and vulnerable to foreign maritime powers. Since England could never conquer Scotland, its solution was to coopt the Scottish elite, who reciprocated, culminating in a merger of the two monarchies and then the two states in the seventeenth and eighteenth centuries. The British empire provided Scotland with peace, prosperity, and access to the rest of the world. History and geopolitics do not imply that Scottish independence is impossible, i.e. that union with the rest of Britain is inevitable and permanent. The Anglo-Scots union is only 314 or 418 years old, whereas Scotland existed as a recognizable kingdom for roughly six centuries prior to the joining of the crowns in 1603. It is entirely possible for Scotland to secede and break up the union known as Great Britain. The principle of rule by consent and modern democratic ideology make it difficult for London and Westminster to force Scotland into subjection like in the old days. In particular, American hegemony over Europe since WWII and the rise of the European Union have created a pathway for Scottish independence. England is no longer the indispensable gateway to peace and prosperity. Scotland can exist independently under the EU’s economic umbrella and the American security umbrella.   Europe has always played a major role in Scotland’s political fate and has always held the key to independence. Independence usually failed because European powers failed to devote large and steady resources to supporting Scotland militarily and economically. France was Scotland’s greatest patron and would lend its support for Scottish rebellion. But France also consistently failed Scotland (and Ireland) at critical junctures when independence might have been obtained. This is because France’s interests lay in distracting England rather than adopting Scotland. Chart 5Scottish Energy Production In Decline United Kingdom Stays United United Kingdom Stays United Today’s unified European continent could be a much greater patron than France ever was alone. The EU could assure Scotland of investment and access to markets even in the face of British resistance. However, the EU is still not politically unified: some members fear separatism in their own borders and therefore tend to oppose Scottish accession. It is possible that the EU could overcome this difficulty but only after a series of major events (on which more below). It took an American empire to clear the way for Irish independence. But Ireland has the moat of the Irish Sea – and the United Kingdom still retained Northern Ireland. Today the United States can be expected to keep its distance from quarrels within the UK or between the UK and EU. However, it does not have an interest in Scottish secession or any other disintegration of the UK, whether from a global security point of view (the West’s conflict with Russia) or even from the point of view of US grand strategy relative to Europe (prevention of a European empire that could challenge the US). An independent Scotland would struggle economically. Its declining base of fossil fuel reserves illustrates the problem of generating sufficient revenue to maintain the Scandinavian-style social welfare state that Scotland’s nationalists imagine (Chart 5). Scottish nationalists are keen to embrace renewable energy – and the Scottish Greens are pro-independence – yet Scotland is not a manufacturing powerhouse that will produce its own solar panels and windmills. In the face of economic difficulties, Scotland would become politically divided like it was for most of its history prior to union with England. England would revert to an obstructive or sabotaging role. It is telling that the Scottish voter turnout in the 2014 independence referendum was very strong – much stronger than in other recent elections and plebiscites, including the Brexit referendum in Scotland (Table 1). The implication is that it is much harder for Scotland to strike out on its own than it appears. Opinion polling cited above suggests that neither Brexit nor the COVID-19 pandemic has moved the needle decisively in the direction of independence. If anything it is the opposite. The Scottish National Party has lost momentum since 2014 and is losing momentum in advance of today’s local election, which has been pitched as the opportunity to make a second go at independence (Chart 6). Table 1Scotland: High Turnout In 2014 Independence Referendum Implies Firm Conclusion To Stay In UK United Kingdom Stays United United Kingdom Stays United Chart 6Scottish National Party Losing Momentum Just Ahead Of Holyrood Election Scottish National Party Losing Momentum Just Ahead Of Holyrood Election Scottish National Party Losing Momentum Just Ahead Of Holyrood Election Bottom Line: History suggests that the geopolitical and macroeconomic barriers to a unified and independent Scottish state are higher and stronger than they may appear at any given time, including the inevitable periods of tensions with England like today. The UK’s Saving Graces A fair question is whether the UK’s decision to leave the EU since 2016 has changed Scotland’s calculus. Brexit may also have affected the international context, reducing the EU’s willingness to intervene on the UK’s behalf and discourage Scottish ambitions. However, a handful of factors supports the continuation of the union despite Scotland’s grievances. The UK proved a boon amid COVID-19: While 62% of Scots voted against Brexit, the COVID-19 pandemic and recession have supplanted Brexit as the nation’s chief cause of concern. The UK and Scotland saw a higher rate of deaths during the biggest waves of the pandemic but now the pandemic is effectively over in the UK and Scotland, in stark contrast with the European Union (Chart 7). The UK has provided a net benefit to Scotland by inventing the vaccine and distributing it effectively (Chart 8). Scottish voters would have been worse off had they left the UK in 2014. Of course, Scottish nationalism is apparent in the fact that voters give the credit to Edinburgh while blaming London over its handling of the pandemic (Chart 9). But the underlying material reality – that being part of the UK provided a net benefit – will discourage independence sentiment. The Scottish Conservative Party and Labour Party are both in favor of sustaining the union and have benefited in opinion polling since the pandemic peaked. Chart 7COVID Deaths Collapse In ##br##United Kingdom United Kingdom Stays United United Kingdom Stays United Chart 8Scotland Benefited From UK Vaccine And Rollout United Kingdom Stays United United Kingdom Stays United   Chart 9Scots Praise Edinburgh, Blame London On COVID Handling United Kingdom Stays United United Kingdom Stays United Brexit is a cautionary economic tale: If Brexit is relevant to Scottish voters, it is not the source of grievance that it could have been. Prime Minister Boris Johnson achieved an exit and trade deal at the end of 2019-20 that largely preserves economic ties with the EU. True, the deal has problems that undermine the UK economy and enhance Scottish grievances. But these also serve as a warning to Scots who would attempt to exit the UK, highlighting the economic pitfalls of raising borders and barriers against one’s chief market. The UK’s trade is far more critical to Scotland’s economy than that of the EU (Chart 10).   Chart 10Major Constraint On Scottish Independence United Kingdom Stays United United Kingdom Stays United Unlike in the case of the UK and EU, Scotland shares the same currency and central bank with the UK. Scotland’s large banking sector stands to suffer drastically if the Bank of England ceases to be a lender of last resort. This would become a major problem at least until Scotland could be assured of admission into the EU and Euro Area. Otherwise redenomination into a national currency would deal an even greater financial and economic blow. Scots  would face a far more painful economic divorce from the UK than the UK faced with the EU. The UK’s fiscal blowout helped Scotland: Since the bank run at Northern Rock in 2007, the UK and Scotland have suffered a series of crises. This instability should discourage risk appetite today when contrasted with the possibility of stimulus-fueled economic recovery. In particular, the UK government is no longer pursuing fiscal austerity – an economic policy that fanned the flames of Scottish secession back in 2012. Indeed, the UK tops the ranks of global fiscal stimulus, according to the change in government net lending and borrowing as reported by the IMF. The UK’s outlier status ensures that Scotland receives more fiscal support than it otherwise would have (Chart 11). A brief comparison with comparable countries – Ireland, Belgium, France, Norway, Portugal – reinforces the point. Chart 11Scotland Benefited From UK Fiscal Blowout United Kingdom Stays United United Kingdom Stays United The UK’s aggressive policy of monetary and fiscal reflation is not a coincidence. It stems from the past two decades’ constitutional and political struggles – it is an outgrowth of domestic instability and populism. It includes an industrial policy, a green energy policy, and other rebuilding measures to combat the erosion of the state in the wake of hyper-globalization. Essentially the UK, even under a Tory government, is now about debt monetization and nation-building. While Scotland would have trouble bargaining for its share of EU resources, it benefits from the UK’s shift to government largesse and can use the threat of independence to receive greater funds from the United Kingdom. Geopolitics discourages a fledgling Scottish nation. Scotland hosts naval and air bases of considerable value to the UK, US, and broader NATO alliance. Former US President Trump’s punitive measures against the European allies and open doubts about the US’s commitment to NATO’s collective security illustrated the dangers of western divisions in the face of autocratic regimes like Russia and China. The US and EU are now recommitting to their economic and security bonds under the Biden administration. Scottish independence would undermine this recommitment and as such the small country would pit itself against the US, EU, and NATO. While the US and NATO would ultimately admit Scotland into collective security, for fear of cultivating a neutral Scotland that could eventually be exploited by Russia, they would likely discourage independence ahead of time to prevent a historic division within the UK and NATO. Chart 12No Urgency For A Second Referendum United Kingdom Stays United United Kingdom Stays United As for the EU, the Spanish government has indicated that it would be willing to make an exception for Scottish independence if it were negotiated amicably with the United Kingdom.2 Such statements are doubtful, however, as any successful secession would lend ideological credibility to Spanish secessionism – not only in Catalonia but also in the Basque country and elsewhere. And Spain is not the only country that harbors deep hesitations over Scottish accession to the European Union. Belgium, Slovakia, and Cyprus could also oppose it. It only takes a single veto to halt the whole accession process. Ultimately the EU could accept Scotland, just as would NATO, to avoid the dangers of having a neutral state in a strategic location. But the point is that Scottish voters cannot be certain. For example, Scotland cannot secure EU accession prior to leaving the UK and yet to leave the UK and fail to achieve EU accession would render it a fledgling. This explains why Scottish voters are not eager to hold a new independence referendum (Chart 12). Bottom Line: The UK offers medical, economic, fiscal, and geopolitical advantages to Scotland that independence would revoke. The context of Great Power struggle with Russia and China means that an independent Scotland would probably ultimately be admitted into NATO and the EU – but Scottish voters cannot be certain, a factor that discourages independence at least in the short and medium run. Scottish Hurdles Table 2 highlights the historic results of Scottish elections according to political party, popular vote share, and share of seats in parliament. Early, tentative signs suggest that the Scottish National Party maxed out in 2011. The party has suffered from a leadership schism, offshoot parties, and a distraction of its key message since 2014. The implication is not only that Scottish independence is on ice for now but also that the tumultuous constitutional disagreements are subsiding and voters want to focus on economic recovery. Table 2Scottish National Party Hit High-Water Mark In 2011? United Kingdom Stays United United Kingdom Stays United If the Scottish National Party manages to form a majority coalition capable of pushing forward a second referendum, it will face several hurdles. It will need a UK Supreme Court ruling on the legality of a referendum. If a referendum is declared legal (as it very likely will be), Scotland will need to forge an agreement with Prime Minister Boris Johnson to hold a referendum. If a referendum eventually is held and passes, an exit will need to be negotiated. In a post-Brexit world, investors cannot assume that any referendum will fail or that a referendum is a domestic political ploy that the ruling party has no serious intention of following through. Nevertheless it is true that the Scottish National Party could use the threat of a referendum to agree to negotiate a greater devolution of power from Westminster. The party could hold up England’s concessions as a victory while retaining the independence threat as leverage for a later date. Devolution in the past has strengthened the independence cause, as in the creation of the Scottish parliament in 1999. After all, a referendum loss would be devastating for the nationalists, whereas the threat of a referendum could yield victories without depriving the nationalists of their reason for being. It is notable that First Minister Nicola Sturgeon promised not to hold a “wildcat” referendum, in which Scotland holds a referendum regardless of what Westminster or the UK Supreme Court say. The implication is that Scottish nationalism is looking for a stable way to exit. But if stability is the hope then there is dubious support for independence in the first place. A wildcat referendum is theoretically still an option but a formal process with popular support is much more likely to result in a successful referendum than an informal process with dubious popular support. Chart 13Scotland’s Chronic Deficits Scotland's Chronic Deficits Scotland's Chronic Deficits If Scottish independence succeeded in any wildcat referendum, an extreme controversy would follow as Edinburgh tried to translate this result to the formal political and constitutional sphere. If the referendum were not recognized by the UK then Scotland would be forced to secede unilaterally at greater economic cost. Otherwise a third referendum (second formal referendum) would need to be held to confirm the results. Any third referendum would be irrevocable. As with Brexit, the secessionists would have to carry one or more subsequent elections to execute the political will in the event of secession. The point for investors is that volatility would be prolonged as was the case with Brexit. A major complication in Scottish independence remains the problem of public finances. Scotland’s fiscal standing is weak. Scotland ran a 9.4% of GDP budget deficit prior to COVID-19, excluding transfers from the UK, which compensates for a gap of about 6% of GDP (Chart 13).3 The country maintains generous social spending alongside a low-tax regime. There is no sign of correction as all Scottish parties are proposing more expansive social spending in the parliamentary election. The Scottish National Party is even proposing universal basic income. Scotland’s emergency COVID deficits are larger than the UK’s as well and projections over the coming years suggest that they will stay elevated. Historically economic growth keeps closely in line with the rest of the UK and there is no reason to believe independence would boost growth. The implication is that Scotland would have to curtail spending or raise taxes to come into line with UK-sized deficits, which are not small (Chart 14).4 Of course Scotland would not embrace austerity unless financial market pressure forced it to do so. Chart 14Scottish Deficit Projected Larger Than UK United Kingdom Stays United United Kingdom Stays United Scotland would become a high-debt economy. Its public debt-to-GDP ratio would be about 97%, on a back-of-the-envelope calculation. Back in 2013 estimates ranged around 80% of GDP.5 The Scottish National Party’s Sustainable Growth Commission projected in 2018 – before the pandemic blew an even wider hole in the budget deficit – that deficits would nearly have to be cut in half (i.e. capped at 5% of GDP and falling) to achieve a 50% debt-to-GDP ratio over 10 years.6 This is not going to happen. Scotland would also have to take on a portion of the UK’s national debt if it were to have an amicable divorce from the UK and retain the pound sterling. But then much of its newfound independence would be compromised from the beginning by legacy debt and monetary policy shackles. Similar restrictions would come with EU and euro membership. Any accession process after the pandemic would require conformity to the EU’s growth and stability pact, which limits deficits and debt. Redenomination into a national currency, as noted, would dilute domestic wealth, zap the financial industry, and self-impose austerity. Bottom Line: Even if the Scottish nationalists manage to put together a pro-independence majority in Edinburgh, they face a complex process in setting up a referendum. Its passage is doubtful based on the current evidence. But obviously in the wake of Brexit investors should not assume that a referendum attempt will fail or that a successful referendum will be thwarted by parliament after a “leave” vote. The timeline for a second referendum is not imminent – and Scottish independence is highly unlikely, albeit possible at some future date given that middle-aged Scots lean in favor of independence.   Investment Takeaways We will conclude with two market takeaways: Chart 15UK Stocks Recovering From Referendum Fever UK Stocks Recovering From Referendum Fever UK Stocks Recovering From Referendum Fever Chart 16Hindsight On How To Play A Constitutional Struggle Hindsight On How To Play A Constitutional Struggle Hindsight On How To Play A Constitutional Struggle The UK’s referendum fever has compounded political uncertainty and contributed to negative factors for the UK equity market over the past decade. A segmentation of the FTSE 100 according to country shows that Scottish-based companies’ share prices rolled over in the aftermath of the 2014 referendum, while the non-Scottish segment performed better (Chart 15). The implication is not that the referendum caused stocks to fall but that the 2014 independence push was the result of national exuberance supercharged by high commodity prices. Enthusiasm for independence has been flat since that time. What is clear is that financial markets look even less favorably upon Scottish equities than other British equities – another sign of the economic problems that will ultimately discourage Scottish voters from going it alone. In advance of the Scottish election, we went tactically long the Swiss franc relative to the British pound to capitalize on jitters that we expected to hit the currency. This trade was in keeping with the long fall of GBP-CHF over the past decade (Chart 16). But the stronger forces of global stimulus, vaccination, economic normalization, and recovery will soon provide a tailwind for sterling yet again. Therefore we are booking 1% gains and shifting to a more optimistic outlook on the pound. With the Brexit saga and the COVID crisis in the rear view mirror, and the tail risk of Scottish independence unlikely, the pound can resume its upward trajectory – at least relative to the Swiss franc. International equities and cyclicals are also poised to continue rising as the world recovers. We recommend investors go long the FTSE 100 relative to developed markets excluding the United States. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Jeremy Black, “The Legacy of the Scottish Referendum,” Foreign Policy Research Institute E-Notes, September 22, 2014, fpri.org. 2 See Akash Paun et al, "Scottish Independence: EU Membership And The Anglo-Scottish Border," Institute For Government, March 2021, instituteforgovernment.org.uk. 3 See Eve Hepburn, Michael Keating, and Nicola McEwen, "Scotland’s New Choice: Independence After Brexit," Centre on Constitutional Change, 2021, centreonconstitutionalchange.ac.uk. 4 See David Phillips, "Updated projections of Scotland’s fiscal position – and their implications," Institute for Fiscal Studies, April 29, 2021, ifs.org.uk. 5 Granting that the UK’s general government gross debt stood at GBP 1.88 trillion at the end of 2020, and assuming that Scotland takes on a share of this debt equivalent to Scotland’s share of the UK’s total population and output (roughly 8%), the Scottish debt would stand at GBP 150 billion out of a Scottish GDP at current market prices of GBP 156 billion, or 97% of GDP. For the 2013 estimate of at least 80% of GDP, see David Bell, "Scottish Independence: Debt And Assets," Centre on Constitutional Change, December 3, 2013, centreonconstitutionalchange.ac.uk.  6 Scottish National Party, "Part B: The Framework & Strategy for the Sustainable Public Finances of an Independent Scotland," Sustainable Growth Commission, May 2018, sustainablegrowthcommission.scot. The commission’s debt curbs will have to be revised in the wake of COVID-19. For discussion see Chris Giles and Murie Dickie, "Independent Scotland would face a large hole in its public finances," Financial Times, April 2, 2021, ft.com.  

Highlights A slower money and credit growth in China will eventually generate disinflationary pressures by weighing on demand for commodities. The PBoC has shifted its inflation anchor and policy framework to target core CPI and the PPI rather than headline CPI. Beijing is scaling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. In the next six to nine months we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. We are long CSI500 relative to China’s A shares. The CSI500 has a larger exposure to the global economy and lower valuation relative to China’s broad onshore market.  Feature As a follow up to last week’s report, we look at another topic raised in recent client meetings: whether rapidly rising producer prices in China will morph into a broad-based inflationary risk and how macroeconomic policies will evolve to counter such a risk. Clients who believe that the ongoing producer price inflation is transitory cited China’s low consumer price inflation, and slowing money and credit growth, as leading indicators of budding disinflationary pressures. Advocates of sustained inflation pointed to robust recoveries and demand among advanced economies, extremely accommodative monetary conditions worldwide, massive fiscal stimulus in the US, a weak US dollar, and supply constraints. It remains to be seen what the worldwide pandemic’s impact will be on the balance between global production capacity and aggregate demand. In this report we analyze the PBoC’s inflation target and policy framework, and conclude that while China’s monetary policy has not become more hawkish, policy tightening seems to be taking place on the fiscal front. Is Inflation In China A Risk? It is debatable whether the strong rebound in GDP growth in Q4 last year and in Q1 this year has closed China’s output gap and will lead to widespread inflation. Given data distortions due to low-base effects from the previous year and uncertainty about China’s productivity and labor force growth, any calculation of the output gap will be unreliable. In addition, China’s employment statistics lack cyclicality and cannot be used to gauge inflationary pressure stemming from wage growth and unit labor costs.     Chart 1A Rollover In Credit Growth Will Weigh On Chinese Demand For Commodities A Rollover In Credit Growth Will Weigh On Chinese Demand For Commodities A Rollover In Credit Growth Will Weigh On Chinese Demand For Commodities Our cyclical view of inflation is therefore based on the framework that the ongoing moderation in China's money and credit growth will eventually generate disinflationary pressures by weighing on the country’s demand for and price of commodities (Chart 1).  Furthermore, behind a resilient PPI, there are suggestions that the strength in China’s economy is still bifurcated. A narrow-based uptrend in the PPI lacks the ground for sustained inflation, and is unlikely to trigger a general tightening in monetary policy.  While mounting global prices for raw materials propelled strong upstream PPI, producer prices for consumer goods and core consumer price inflation remain very subdued (Chart 2).  The inconsistency in producer prices among various industries highlight the unevenness of the economic recovery and, importantly, persistently muted household consumption (Chart 3). Chart 2A Bifurcated Economic Recovery A Bifurcated Economic Recovery A Bifurcated Economic Recovery Chart 3A Muted Recovery In Household Consumption A Muted Recovery In Household Consumption A Muted Recovery In Household Consumption Chart 4Weak Price Transmission From Upstream To Downstream Industries Weak Price Transmission From Upstream To Downstream Industries Weak Price Transmission From Upstream To Downstream Industries The transmission from upstream industrial PPI to the middle and downstream sectors has also been weak (Chart 4). It is evidenced in the faster growth of manufacturing output volume compared with price increases (Chart 5). This contrasts with the previous inflationary cycles, as well as mining and ferrous metals where surging prices for raw materials have way surpassed recovery in output volume (Chart 6). Given that price changes are more important to corporate profits than volume changes, Chinese middle-to-downstream industries face downward pressure on their profit margins and will likely deliver disappointing profits, despite a strong rebound in production. Chart 5China's Manufacturing Recovery: Stronger Volume Than Prices China's Manufacturing Recovery: Stronger Volume Than Prices China's Manufacturing Recovery: Stronger Volume Than Prices Chart 6China's Upstream Industries: Prices Surged Faster Than Production China's Upstream Industries: Prices Surged Faster Than Production China's Upstream Industries: Prices Surged Faster Than Production Furthermore, PMI input prices, which lead core CPI by about nine months, rolled over in April (Chart 7). While it is too soon to conclude that input prices have peaked, it is implied that upward pressure on core CPI from input prices may start to ease in 2H21. Bottom Line: So far there is no sign that elevated upstream producer prices will create sustainable inflationary pressure on consumer prices. Hence our view is that the PBoC will not respond to a rising PPI by further tightening monetary policy. Chart 7PMI Input Prices Have Rolled Over PMI Input Prices Have Rolled Over PMI Input Prices Have Rolled Over Chart 8Core CPI And PPI Have Been The PBoC's Inflation Targets Since 2015 Core CPI And PPI Have Been The PBoC's Inflation Targets Since 2015 Core CPI And PPI Have Been The PBoC's Inflation Targets Since 2015 The PBoC’s Inflation Target Since 2015, China’s monetary tightening cycles have closely correlated with a combination of the core CPI and PPI instead of headline CPI (Chart 8). The shift to targeting core CPI and PPI occurred despite the central bank’s frequent mention of headline CPI as its inflation target. The reasons for the shift are twofold. First, swings in food and fuel prices have become much larger since 2014, often dominating fluctuations in headline CPI (Chart 9).  Secondly, the price swings were often driven by supply-side factors and did not reflect changes in demand. Therefore, monetary policies could do little to mitigate inflationary or deflationary pressures. Furthermore, the PPI seems to play a greater role in the PBoC’s monetary policymaking than the headline and core CPI (Chart 10).  The tighter relationship between the de facto policy rate and the PPI is not surprising, given that China’s ex-factory price inflation reflects changes in corporate pricing, profit, and inventory cycles – all are driven by the country’s money supply and credit cycles.  Chart 9Large Swings In Food And Energy Prices Distorted Headline CPI In Recent Years Large Swings In Food And Energy Prices Distorted Headline CPI In Recent Years Large Swings In Food And Energy Prices Distorted Headline CPI In Recent Years Chart 10PPI Plays A Greater Role In The PBoC's Monetary Policymaking PPI Plays A Greater Role In The PBoC's Monetary Policymaking PPI Plays A Greater Role In The PBoC's Monetary Policymaking The relationship between the 7-day repo rate - the de jure policy rate - and the PPI has broken down since 2015 (Chart 11). Meanwhile, the 3-month repo rate has maintained a close relationship with the PPI (Chart 10, bottom panel). The change in the relationship is because the PBoC shifted its policy to target interest rates instead of the quantity of money supply since 2015 (Chart 12). Moreover, since 2016 the PBoC has generated monetary policy tightening measures through changes in its Macro Prudential Assessment Framework (MPA) rather than directly through interest rate hikes.  Chart 11Relationship Between The 7-Day Repo Rate And The PPI Has Broken Down Since 2015... Relationship Between The 7-Day Repo Rate And The PPI Has Broken Down Since 2015... Relationship Between The 7-Day Repo Rate And The PPI Has Broken Down Since 2015... Chart 12...Due To Monetary Policy Regime Shifted ...Due To Monetary Policy Regime Shifted ...Due To Monetary Policy Regime Shifted Bottom Line:  The PBoC has shifted its inflation anchor and policy framework since 2015. Core CPI and the PPI are now the main inflation targets. A Quiet Fiscal Tightening? Despite a jump in the PPI, the 3-month repo rate fell sharply in the past two months (Chart 10 on page 6, bottom panel).  It is possible that the PBoC considers escalating producer prices as transitory and, therefore, intends to keep its overall policy stance unchanged. However, the PBoC’s relaxed policy response towards inflation risk may be explained by Beijing’s quiet tightening on the fiscal front. Chart 13The Central Bank Has Made Little Interbank Liquidity Injections Lately The Central Bank Has Made Little Interbank Liquidity Injections Lately The Central Bank Has Made Little Interbank Liquidity Injections Lately The PBoC can hold its policy rates steady by supplying adequate liquidity to the interbank system through open market operations or by reducing the demand for liquidity. On a net basis, the PBoC has recently injected very little liquidity into the interbank system, implying that banks’ liquidity demand has likely softened (Chart 13).  This might be a sign of weakening credit origination. In a previous report we discussed how fiscal stimulus has become a more relevant driver of China’s credit origination since the onset of the 2014/15 economic downcycle. A rising 3-month SHIBOR can be the result of rapid fiscal and quasi-fiscal expansions, which occurred in Q3 last year. A flood of local government bond issuance drained liquidity from commercial banks, which boosted the banks’ needs to borrow money from the interbank system and pushed up interbank rates. Despite higher interest rates, credit growth soared in Q3 as fiscal multiplier provided an imminent and powerful reflationary force to the economy. In contrast, local government bond issuance was down sharply in the first four months of this year, compared with 2019 and 2020. Local governments sold 222.7 billion yuan of special-purpose bonds (SPBs) from January to April, a plunge from 730 billion yuan of debt sold in the same period in 2019 and 1.15 trillion yuan in 2020. The total local government bond issuance in Q1 this year has also been 36% and 44% lower than in Q1 2019 and 2020, respectively. A lack of local governments’ appetite to borrow coupled with a shortage in profitable infrastructure projects might have contributed to the sharp drop in bond issuance this year. Local government financing and spending have been under increased scrutiny this year. Following the State Council Executive Meeting in late March, in which Premier Li Keqiang pledged to reduce government leverage ratio and raise regulatory standards on infrastructure investment, Beijing suspended two high-speed rail projects that were initiated by provincial governments. Messages from Politburo’s meeting last week reinforced our view that policymakers may be scaling back fiscal support while further tightening regulations in the property sector. Both aspects have the potential to cool China’s demand for industrial metals and global industrial material prices (Chart 14 and Chart 15). Chart 14A Slowdown In Chinese Manufacturing Demand Will Have A Greater Impact On Global Industrial Material Prices A Slowdown In Chinese Manufacturing Demand Will Have A Greater Impact On Global Industrial Material Prices A Slowdown In Chinese Manufacturing Demand Will Have A Greater Impact On Global Industrial Material Prices Chart 15Lower Housing Demand In China Will Help To Cool Industrial Metal Prices Lower Housing Demand In China Will Help To Cool Industrial Metal Prices Lower Housing Demand In China Will Help To Cool Industrial Metal Prices We expect the intensity of policy tightening to reach its peak between mid-year to third-quarter 2021. It is unclear at this point whether policymakers are willing to allow local governments to significantly undershoot their SPB quota for this year. Local governments reportedly experienced a shortage in profitable investment projects towards the end of last year, and thus, parked more than 10% of proceeds from 2020 SPB issuance at the central bank. The central government may be taking a wait-and-see attitude this year, and saving more fiscal dry powder for later this year when the economic slowdown becomes more meaningful. Bottom Line: Beijing is pulling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. The deleveraging efforts will curb China’s demand for commodities, and may work to ease inflationary pressure on prices for raw materials. Investment Conclusions The outlook for China’s risk asset prices remains bearish, at least in the next six months. If the credit and fiscal impulse slow enough to depress corporate pricing power, inflation will not be a problem because disinflationary pressures will resurface. However, the growth of corporate profits will disappoint (Chart 16). Beijing may be saving more fiscal dry powder for later this year. Still, SPBs are only a small part of local governments’ financing source for infrastructure projects. Given the central government’s renewed focus on reducing public debt, policymakers are unlikely to unleash fiscal power to significantly boost infrastructure spending or economic growth. In the next six to nine months, we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. With this week's report, we initiate a long position on the CSI500 index, which has a larger exposure to the global market and lower valuation relative to China’s broad onshore market (Chart 17).  Chart 16Aggregate Corporate Profit Growth Will Slow Even Though Inflation Is No Longer An Issue Aggregate Corporate Profit Growth Will Slow Even Though Inflation Is No Longer An Issue Aggregate Corporate Profit Growth Will Slow Even Though Inflation Is No Longer An Issue Chart 17Long CSI500/Broad Market Long CSI500/Broad Market Long CSI500/Broad Market   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Sweden’s economic recovery is robust and will deepen. Policy is accommodative. Very few advanced economies will benefit as much from the global economic rebound. The labor market will tighten, capacity utilization will increase, and inflation will rise faster than the Riksbank forecasts. On a one- to two-year investment horizon, the SEK is a buy against both the USD and the EUR. Despite their pronounced outperformance, Swedish stocks possess significantly more upside against both Eurozone and US equities over the remainder of the cycle. Swedish industrials will beat their competitors in both these markets. Nonetheless, China’s policy tightening creates a meaningful tactical risk, which selling Norwegian stocks can hedge. Italy’s fiscal plan constitutes a new salvo in Europe’s efforts to avoid last decade’s mistakes. Feature Last week, the Swedish Riksbank did not follow in the footsteps of the Norges Bank. The Swedish central bank acknowledged that the economy is performing better than anticipated and that the housing market is gaining in strength; yet, it refrained from hinting at any forthcoming adjustment to its policy rate or the pace of its asset purchase program. The positive outlook for the Swedish economy will force the Riksbank to tighten policy significantly before the ECB. As a result, we expect the Swedish Krona to outperform the euro and the US dollar. Moreover, investors should continue to overweight Swedish equities due to their large exposure to industrials and financials, even if they have already significantly outperformed the Euro Area. Sweden’s Economic Outlook The Swedish economy will accelerate, which will put pressure on resource utilization and fan inflationary risk in the years ahead. The degree of stimulus supporting Sweden is consequential. Chart 1A Dual Labor Market A Dual Labor Market A Dual Labor Market On the fiscal front, the government support measures that have been announced since the beginning of the COVID-19 crisis currently amount to SEK420bn, or SEK197bn for 2020 (4% of GDP), and SEK223bn for 2021 (4.5% of GDP). Moreover, generous labor market protection and part-time employment schemes meant that the number of employees in permanent employment contracts remained stable during the pandemic (Chart 1). Thus, the bulk of the rise in Swedish unemployment came from workers on fixed-term contracts. Monetary policy remains very accommodative as well. The Riksbank left its repo rate unchanged at 0% through the crisis, but cut its lending rate from 0.75% to 0.1%. More importantly, the Swedish central bank is aggressively injecting liquidity into the economy. It set up a SEK500bn funding-for-lending facility in order to incentivize bank lending to the nonfinancial private sector, and started a SEK700bn QE program, which as of Q1 2021 had purchased SEK380bn securities and which will purchase another SEK120bn in Q2, with covered bonds issued by banks accounting for 70% of it. As a result, the amount of securities held on the Riksbank balance sheet will nearly triple by year end (Chart 2). Chart 2The Riksbank Is Open For Business Take A Chance On Sweden Take A Chance On Sweden Beyond the monetary and fiscal stimulus, many factors point to greater economic strength for Sweden. Despite a slow start to the process, as of last week, nearly 30% of the Swedish population had received at least one vaccine dose, which is broadly in line with vaccination rates prevalent in France or Germany. Crucially, the pace of vaccination is accelerating at a rate of 13% per week. Even if this second derivative slows, more than 70% of the population will have received at least one dose by this summer. Thus, greater mobility is in the cards during the second quarter, which will boost household spending. Chart 3The Wealth Effect The Wealth Effect The Wealth Effect The housing market also favors a pick-up in consumption. The HOX housing price index is growing at a 15% annual rate, its fastest expansion in over 5 years. As a result of the wealth effect, this rapid appreciation is consistent with a swift improvement in the growth rate of household expenditures (Chart 3). Moreover, spending on durable goods now stands 1.3% above its pre-pandemic levels, while spending on non-durables is back to pre-pandemic levels. This context suggests that increased mobility translates into greater spending. The industrial sector remains a particularly bright spot in the Swedish economy. Sweden is extremely sensitive to the global industrial and trade cycle, because exports represent 45% of GDP. Moreover, the highly cyclical intermediate and capital goods comprise 56% of the country’s foreign shipments, which accentuates the beta of the Swedish economy. BCA Research remains optimistic about the global industrial cycle. Sweden will reap a significant dividend. Already the Swedish PMI points to stronger industrial production, and the index’s exports component is roaring ahead (Chart 4). The potential for a greater uptake in consumption, capex, and durable goods spending in the rest of the EU (Sweden’s largest trading partner) bodes well for the Swedish manufacturing sector. Additionally, if the collapse in the US inventory-to-sales ratio is any indication for the rest of the world, a global restocking cycle is forthcoming, which will further boost Swedish industrial activity (Chart 4, bottom panels). Finally, global public infrastructure plans are on the rise, which will also help Sweden. Chart 4Sweden Is well Placed Sweden Is well Placed Sweden Is well Placed Chart 5Brightening Labor Market Prospects Brightening Labor Market Prospects Brightening Labor Market Prospects In this context, the Swedish labor market should tighten significantly in the approaching quarters. Already, job vacancies are rebounding, and redundancy notices have normalized, which matches both the GDP growth surprise in Q1 and the continued rise in the NIER Sweden Economic Tendency Indicator. Furthermore, the employment component of the PMIs stands at 58.9 and is consistent with a sharp improvement in job growth over the coming year (Chart 5). The expected labor market growth will contribute to an increase in capacity utilization, which will place upward pressure on wages and inflation. When the 12-month moving average of US and Eurozone imports rises, so does the Riksbank Resource Utilization Indicator, because global trade has such a pronounced effect on the Swedish economy (Chart 6). Meanwhile, greater resource utilization leads to accelerated inflation, greater labor shortages, and rising unit labor costs (Chart 7).  Chart 6CAPU Will Rise CAPU Will Rise CAPU Will Rise Chart 7The Coming Pressure Buildup The Coming Pressure Buildup The Coming Pressure Buildup Bottom Line: As a result of generous stimulus and the global economic recovery, the Swedish economy is set to continue its rebound. Consequently, employment and capacity utilization will improve meaningfully, which will lead to a resurgence of inflation and wages in the coming 24 months. Investment Implications On a 12 to 24 months horizon, we remain positive on the Swedish krona and Swedish equities. Fixed Income And FX Chart 8Three Hikes By 2025 Three Hikes By 2025 Three Hikes By 2025 The backend of the Swedish OIS curve only discounts 75bps of hikes by 2025. This pricing is too modest (Chart 8). The Swedish economy will rebound further as the vaccination campaign advances, and rising house prices and household indebtedness will fan growing long-term risk to financial stability, both of which suggest that the Riksbank will have to change its tack in 2022. The great likelihood that the Fed will start tapering off its asset purchase toward the end this year, that the ECB will follow sometime in 2022, and that the Norges Bank will be increasing interest rates next year will give more leeway to the Swedish central bank. A wider Sweden/Germany 10-year government bond spread is not an appealing vehicle to play a more hawkish Riksbank down the road. This spread hit a 23-year high in March and now rests at 62bps or its 98th percentile since 2000. Moreover, the terminal rate proxy embedded in the German money market curve is currently so low that the spread between Sweden’s and the Eurozone’s terminal rate proxy stands near a record high. Hence, German yields already embed much more pessimism than Swedish ones. Nonetheless, BCA recommends a below benchmark duration exposure within the Swedish fixed-income space, as we do for other government bond markets around the world.1 A bullish bias toward the SEK is a bet on the Riksbank that offers a very appealing risk/reward ratio, according to BCA Research’s Foreign Exchange Strategy strategists.2 The krona is very cheap against both the euro and the US dollar, trading at 9% and 29% discounts to purchasing power parity, respectively. Moreover, the Swedish current account stands at 5.2% of GDP, compared to 2.3% and -3.1% for the Euro Area and the US, creating a natural underpinning under the SEK. Chart 9The SEK Loves Growth The SEK Loves Growth The SEK Loves Growth Over the coming 12 to 24 months, cyclical forces favor selling EUR/SEK and USD/SEK on any strength. The SEK is one of the most cyclical G-10 currencies and has one of the strongest sensitivities to the US dollar. Hence, our positive global economic outlook and our FX strategists negative view on the greenback are synonymous with a weak USD/SEK. These same factors also mean that the krona will appreciate more than the euro, as the negative correlation between EUR/SEK and our Boom/Bust Indicator and global earnings growth illustrate (Chart 9). Equities We also like Swedish equities, but the state of the Swedish economy and the evolution of the Riksbank policy surprise have a limited impact on Swedish equities. The Swedish bourse is mostly about the evolution of the global business cycle. The Swedish benchmark heightened sensitivity to the global business cycle reflects its massive overweight in deep cyclicals, with industrials, financials, consumer discretionary, and materials accounting for 38.4%, 26.1%, 9.7% and 3.7% of the MSCI index respectively, or 78% altogether (Table 1). As a result, BCA’s preference for global cyclicals at the expense of defensives and this publication’s fondness for the recovery laggards like the industrial and financial sectors automatically translate into a favorable bias toward Sweden’s stocks.3 Table 1Mamma Mia! That’s A Lot Of Cyclicals Take A Chance On Sweden Take A Chance On Sweden Valuations offer a more complex picture, but they do not diminish our predilection for Sweden. Swedish equities trade at a discount to US stocks but at a premium to Euro Area ones (Chart 10). However, Swedish stocks offer higher RoEs and profit margins than both the US and the Euro Area, while also sporting lower leverage (Chart 11). Thus, their valuation premium to Euro Area stocks is warranted and their discount to US ones is excessive, especially when rising yields hurt the relative performance of the growth stocks that dominate US indexes. Chart 10Swedish Discounts And Premia Swedish Discounts And Premia Swedish Discounts And Premia Chart 11Profitable Sweden Profitable Sweden Profitable Sweden The outlook for Swedish earnings is appealing, both in absolute and relative terms. The Swedish market’s extreme sensitivity to global economic activity means that Sweden’s EPS increase and beat US profits when the Riksbank Resource Utilization Indicator expands (Chart 12). These relationships are artefacts of the Swedish economy’s pro-cyclicality, which causes capacity utilization to interweave tightly with the global business cycle (Chart 6). Chart 12The Winner Takes It All The Winner Takes It All The Winner Takes It All Chart 13Better Capex Play Than You Better Capex Play Than You Better Capex Play Than You Global capex and infrastructure spending favor Swedish equities compared to Euro Area ones. Over the past thirty years, Sweden’s stocks have outperformed those of the Eurozone when capital goods orders in the advanced economies have expanded (Chart 13). This reflects the Swedish benchmark’s large overweight in industrials, a sector that is the prime beneficiary of global capex. Capital goods orders are recovering well, and their growth rate can climb higher, especially as western multinationals announce capex plans and as governments from the US to Italy intend to ramp up infrastructure spending. Moreover, the large pent-up demand for durable goods in the Eurozone further enhances the potential of industrial firms, and thus, of Swedish equities.4  Chart 14Another Sign Of Pro-Cyclicality Another Sign Of Pro-Cyclicality Another Sign Of Pro-Cyclicality BCA Research’s positive cyclical stance on commodities offers another reason to overweight Sweden’s market relative to that of the US and the Euro Area. Our Commodity and Energy Strategy sister service anticipates significant further upside for natural resources, especially base metals, over the remainder of the business cycle.5 Commodity prices still have room to rally, because demand will grow as the global economy continues to recover and because the supply of natural resources has been constrained by a decade of low investment. As a result, rising metal prices will symptomatize strong economic activity around the world and will incentivize capex in commodity extraction, both of which will boost the revenue of industrial firms. Furthermore, commodity price inflation often corresponds with rising yields, which boosts financials as well. These relationships explain the Swedish stocks’ outperformance of US and Eurozone stocks, when natural resource prices rally, despite the former’s low exposure to materials (Chart 14). At the sector level, the appeal of Swedish industrials relative to those of the Eurozone and the US completes the rationale to favor Swedish equities in a global portfolio. Swedish industrials are just as profitable as US ones and are more so than Euro Area ones, while having significantly lower leverage than either of them (Chart 15). Additionally, for the past two years, the EPS growth of Swedish industrials has bested that of US and Eurozone ones. Yet, their forward P/E ratio trades in line with the US and the Euro Area, while the sell-side’s long-term relative earnings growth estimate is too depressed (Chart 16). The same observations are valid when comparing Swedish industrials to French or German ones. Hence, in the context of a global business cycle upswing, buying Swedish industrials while selling their US and Euro Area competitors is an appealing pair trade, especially since it also involves short USD/SEK and short EUR/SEK bets. Chart 15Attractive Swedish Industrials... Attractive Swedish Industrials... Attractive Swedish Industrials... Chart 16...And Not Expensive ...And Not Expensive ...And Not Expensive Despite our optimism toward Swedish stocks on a 12 to 24 months basis, investors must hedge a near-term risk. Chinese authorities are aiming to contain financial excesses and trying to restrain credit growth. As we showed four weeks ago, China’s excess reserve ratio is contracting, which points toward a slowdown in the Chinese credit impulse.6 Historically, such a development can hurt global cyclicals, and thus, also Swedish equities. However, BCA Research’s China strategists believe that Beijing will not kill off the Chinese business cycle; thus, the recent disappointment in the Chinese PMI is transitory.7   Chart 17Industrials vs Materials: Europe vs China Industrials vs Materials: Europe vs China Industrials vs Materials: Europe vs China Materials more than industrials will suffer the brunt of a China slowdown, as the re-opening trade and capex cycle among advanced economies will create a buffer for the latter. Indeed, the performance of global industrials relative to materials stocks correlates with the evolution of the spread between the Euro Area and Chinese PMI (Chart 17). Thus, we recommend selling Norwegian equities to hedge the tactical risk inherent in an overweight on Sweden. As Table 1 above shows, Norway overweighs materials and energy (two sectors greatly exposed to China), hence, a temporary pullback in commodity prices should hurt Norwegian stocks more than Swedish ones. Bottom Line: The SEK is an inexpensive and attractive vehicle to bet on both the global business cycle strength and the Swedish economic recovery. Thus, investors should use any rebound in EUR/SEK and USD/SEK to sell these pairs. Moreover, Swedish stocks greatly overweight cyclical sectors, particularly industrials and materials. This sectoral profile renders Swedish equities as attractive bets on the global economy. Additionally, Swedish shares display alluring operating metrics. As a result, we recommend investors go long Swedish industrials relative to those of the US and Euro Area. They should also overweight Swedish equities against the US and the Eurozone. Consequent to some China-related tactical risks, an underweight stance on Norwegian stocks constitutes an attractive hedge to this Swedish exposure. A Few Words On Italy’s National Recovery And Resilience Plan Mario Draghi’s plan to revive the Italian economy, announced last week, is an important marker of Europe’s changing relationship with fiscal policy. Last decade, excessive austerity contributed to subpar growth, ultimately firing up concerns about debt sustainability in many peripheral economies, and fueled risk premia in Italy and Spain. Under the cover of the current crisis, and in the face of the changing political winds in Brussel and Berlin where fiscal rectitude is not the mantra it once was, national European governments are beginning to propose ambitious fiscal stimulus plans. The National Recovery and Resilience program illustrates these dynamics. The EUR248bn plan is a testament to the importance of the NGEU recovery program as well as the REACT EU recovery fund. Through these facilities, the EU will contribute EUR191.5bn to the fiscal plan via grants and loans. Italy will contribute the remainder of the funds. While the total amount disbursed over the next six years corresponds to 14% of Italy’s 2019 GDP, the Draghi government estimates that the program will add 3.2 percentage points to GDP between 2024 and 2026. Importantly, markets are not rebelling. Despite expectations that Italy would continue to run an accommodative fiscal policy, the BTP/Bund spreads remain stable. We can expect this trend of greater stimulus to be mimicked around the EU. Spain is another large recipient of the NGEU program, and it too is likely to increase stimulus beyond what the EU will fund. France will hold an election in May 2022, and President Macron has all the incentives to stimulate the economy between now and then. If, as we wrote last week, Germany shifts to the left in September, then this outcome will be guaranteed. Bottom Line: The Draghi plan is the first salvo of greater fiscal stimulus in the EU. This trend will help Eurozone growth improve relative to the US over the coming few years. Despite a loose fiscal policy, BTPs and other peripheral bonds will continue to outperform on the back of declining risk premia.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Footnotes 1Please see Global Fixed Income Strategy “GFIS Model Bond Portfolio Q1/2021 Performance Review & Current Allocations: Grand Reopening,” dated April 6, 2021, available at gfis.bcaresearch.com 2Please see Foreign Exchange Strategy “2021 Key Views: Tradeable Themes,” dated December 4, 2020, available at fes.bcaresearch.com 3Please see European Investment Strategy “Summer Of ‘21,” dated March 22, 2021, available at eis.bcaresearch.com 4Please see European Investment Strategy “Winds Of Change: Germany Goes Green,” dated April 23, 2021, available at eis.bcaresearch.com 5Please see Commodity & Energy Strategy “Industrial Commodities Super-Cycle Or Bull Market?” dated March 4, 2021, available at ces.bcaresearch.com 6Please see European Investment Strategy “The Euro Dance: One Step Back, Two Steps Forward,” dated March 29, 2021, available at eis.bcaresearch.com 7Please see China Investment Strategy “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021, available at cis.bcaresearch.com Cyclical Recommendations Structural Recommendations Currency Performance Take A Chance On Sweden Take A Chance On Sweden Fixed Income Performance Government Bonds Take A Chance On Sweden Take A Chance On Sweden Corporate Bonds Take A Chance On Sweden Take A Chance On Sweden Equity Performance Major Stock Indices Take A Chance On Sweden Take A Chance On Sweden Geographic Performance Take A Chance On Sweden Take A Chance On Sweden Sector Performance Take A Chance On Sweden Take A Chance On Sweden Closed Trades

Highlights Biden’s first 100 days are characterized by a liberal spend-and-tax agenda unseen since the 1960s. It is not a “bait and switch,” however. Voters do not care about deficits and debt. At least not for now. The apparent outcome of the populist surge in the US and UK in 2016 is blowout fiscal spending. Yet the US and UK also invented and distributed vaccines faster than others. US growth and equities have outperformed while the US dollar experienced a countertrend bounce. While growth will rotate to other regions, China’s stimulus is on the wane. Of Biden’s three initial geopolitical risks, two are showing signs of subsiding: Russia and Iran. US-China tensions persist, however, and Biden has been hawkish so far. Our new Australia Geopolitical Risk Indicator confirms our other indicators in signaling that China risk, writ large, remains elevated. Cyclically we are optimistic about the Aussie and Australian stocks. Mexico’s midterm elections are likely to curb the ruling party’s majority but only marginally. The macro and geopolitical backdrop is favorable for Mexico. Feature US President Joe Biden gave his first address to the US Congress on April 28. Biden’s first hundred days are significant for his extravagant spending proposals, which will rank alongside those of Lyndon B. Johnson’s Great Society, if not Franklin Delano Roosevelt’s New Deal, in their impact on US history, for better and worse. Chart 1Biden's First 100 Days - The Market's Appraisal Biden's First 100 Days - The Market's Appraisal Biden's First 100 Days - The Market's Appraisal The global financial market appraisal is that Biden’s proposals will turn out for the better. The market has responded to the US’s stimulus overshoot, successful vaccine rollout, and growth outperformance – notably in the pandemic-struck service sector – by bidding up US equities and the dollar (Chart 1). From a macro perspective we share the BCA House View in leaning against both of these trends, preferring international equities and commodity currencies. However, our geopolitical method has made it difficult for us to bet directly against the dollar and US equities. Geopolitics is about not only wars and trade but also the interaction of different countries’ domestic politics. America’s populist spending blowout is occurring alongside a sharp drop in China’s combined credit-and-fiscal impulse, which will eventually weigh on the global economy. This is true even though the rest of the world is beginning to catch up in vaccinations and economic normalization. As for traditional geopolitical risk – wars and alliances – Biden has not yet leaped over the three initial foreign policy hurdles that we have highlighted: China, Russia, and Iran. In this report we will update the view on all three, as there is tentative improvement on the Russian and Iranian fronts. In addition, we will introduce our newest geopolitical risk indicator – for Australia – and update our view on Mexico ahead of its June 6 midterm elections. Biden’s Fiscal Blowout From a macro point of view, Biden’s $1.9 trillion American Rescue Plan Act (ARPA) was much larger than what Republicans would have passed if President Trump had won a second term. His proposed $2.3 trillion American Jobs Plan (AJP) is also larger, though both candidates were likely to pass an infrastructure package. The difference lies in the parts of these packages that relate to social spending and other programs, beyond COVID relief and roads and bridges. The Republican proposal for COVID relief was $618 billion while the Republicans’ current proposal on infrastructure is $568 billion – marking a $3 trillion difference from Biden. In reality Republicans would have proposed larger spending if Trump had remained president – but not enough to close this gap. And Biden is also proposing a $1.8 trillion American Families Plan (AFP). Biden’s praise for handling the vaccinations must be qualified by the Trump administration’s successful preparations, which have been unfairly denigrated. Similarly, Biden’s blame for the migrant surge at the southern border must be qualified by the fact that the surge began last year.1 A comparison with the UK will put Biden’s administration into perspective. The only country comparable to the US in terms of the size of fiscal stimulus over 2019-21 so far – excluding Biden’s AJP and AFP, which are not yet law – is the United Kingdom. Thus the consequence of the flare-up of populism in the Anglo-Saxon world since 2016 is a budget deficit blowout as these countries strive to suppress domestic socio-political conflict by means of government largesse, particularly in industrial and social programs. However, populist dysfunction was also overrated. Both the US and UK retain their advantages in terms of innovation and dynamism, as revealed by the vaccine and its rollout (Chart 2). Chart 2Dysfunctional Anglo-Saxon Populism? Dysfunctional Anglo-Saxon Populism? Dysfunctional Anglo-Saxon Populism? No sharp leftward turn occurred in the UK, where Prime Minister Boris Johnson and his Conservatives had the benefit of a pre-COVID election in December 2019, which they won. By contrast, in the US, President Trump and the Republicans contended an election after the pandemic and recession had virtually doomed them to failure. There a sharp leftward turn is taking place. Going forward the US will reclaim the top rank in terms of fiscal stimulus, as Biden is likely to get his infrastructure plan (AJP) passed. Our updated US budget deficit projections appear in Chart 3. Our sister US Political Strategy gives the AJP an 80% chance of passing in some form and the AFP only a 50% chance of passing, depending on how quickly the AJP is passed. This means the blue dashed line is more likely to occur than the red dashed line. The difference is slight despite the mind-boggling headline numbers of the plans because the spending is spread out over eight-to-ten years and tax hikes over 15 years will partially offset the expenditures. Much will depend on whether Congress is willing to pay for the new spending. In Chart 3 we assume that Biden will get half of the proposed corporate tax hikes in the AJP scenario (and half of the individual tax hikes in the AFP scenario). If spending is watered down, and/or tax hikes surprise to the upside, both of which are possible, then the deficit scenarios will obviously tighten, assuming the economic recovery continues robustly as expected. But in the current political environment it is safest to plan for the most expansive budget deficit scenarios, as populism is the overriding force. Chart 3Biden’s Blowout Spending Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s campaign plan was even more visionary, so it is not true that Biden pulled a “bait and switch” on voters. Rather, the median voter is comfortable with greater deficits and a larger government role in American life. Bottom Line: The implication of Biden’s spending blowout is reflationary for the global economy, cyclically negative for the US dollar, and positive for global equities. But on a tactical time frame the rotation to other equities and currencies will also depend on China’s fiscal-and-credit deceleration and whether geopolitical risk continues to fall. Russia: Some Improvement But Coast Not Yet Clear US-Russia tensions appeared to fizzle over the past week but the coast is not yet clear. We remain short Russian currency and risk assets as well as European emerging market equities. Tensions fell after President Putin’s State of the Nation address on April 21 in which he warned the West against crossing Russia’s “red lines.” Biden’s sanctions on Russia were underwhelming – he did not insist on halting the final stages of the Nord Stream II pipeline to Germany. Russia declared it would withdraw its roughly 100,000 troops from the Ukrainian border by May 1. Russian dissident Alexei Navalny ended his hunger strike. Putin attended Biden’s Earth Day summit and the two are working on a bilateral summit in June. Chart 4Russia's Domestic Instability Will Continue Russia's Domestic Instability Will Continue Russia's Domestic Instability Will Continue De-escalation is not certain, however. First, some US officials have cast doubt on Russia’s withdrawal of troops and it is known that arms and equipment were left in place for a rapid mobilization and re-escalation if necessary. Second, Russian-backed Ukrainian separatists will be emboldened, which could increase fighting in Ukraine that could eventually provoke Russian intervention. Third, the US has until August or September to prevent Nord Stream from completion. Diplomacy between Russia and the US (and Russia and several eastern European states) has hit a low point on the withdrawal of ambassadors. Fourth, Russian domestic politics was always the chief reason to prepare for a worse geopolitical confrontation and it remains unsettled. Putin’s approval rating still lingers in the relatively low range of 65% and government approval at 49%. The economic recovery is weak and facing an increasingly negative fiscal thrust, along with Europe and China, Russia’s single-largest export destination (Chart 4). Putin’s handouts to households, in anticipation of the September Duma election, only amount to 0.2% of GDP. More measures will probably be announced but the lead-up to the election could still see an international adventure designed to distract the public from its socioeconomic woes. Russia’s geopolitical risk indicators ticked up as anticipated (Chart 5). They may subside if the military drawdown is confirmed and Biden and Putin lower the temperature. But we would not bet on it. Chart 5Russian Geopolitical Risk: Wait For 'All Clear' Signal Russian Geopolitical Risk: Wait For 'All Clear' Signal Russian Geopolitical Risk: Wait For 'All Clear' Signal Bottom Line: It is possible that Biden has passed his first foreign policy test with Russia but it is too soon to sound the “all clear.” We remain short Russian ruble and short EM Europe until de-escalation is confirmed. The Russian (and German) elections in September will mark a time for reassessing this view. Iran: Diplomacy On Track (Hence Jitters Will Rise) While Russia may or may not truly de-escalate tensions in Ukraine, the spring and summer are sure to see an increase in focus on US-Iran nuclear negotiations. Geopolitical risks will remain high prior to the conclusion of a deal and will materialize in kinetic attacks of various kinds. This thesis is confirmed by the alleged Israeli sabotage of Iran’s Natanz nuclear facility this month. The US Navy also fired warning shots at Iranian vessels staging provocations. Sporadic attacks in other parts of the region also continue to flare, most recently with an Iranian tanker getting hit by a drone at a Syrian oil terminal.2 The US and Iran are making progress in the Vienna talks toward rejoining the 2015 nuclear deal from which the US withdrew in 2018. Iran pledged to enrich uranium up to 60% but also said this move was reversible – like all its tentative violations of the Joint Comprehensive Plan of Action (JCPA) so far (Table 1). Iran also offered a prisoner swap with the US. Saudi Arabia appears resigned to a resumption of the JCPA that it cannot prevent, with crown prince Mohammed bin Salman offering diplomatic overtures to both the US and Iran. Table 1Iran’s Nuclear Program And Compliance With JCPA 2015 Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Still, the closer the US and Iran get to a deal the more its opponents will need to either take action or make preparations for the aftermath. The allegation that former US Secretary of State John Kerry’s shared Israeli military plans with Iranian Foreign Minister Javad Zarif is an example of the kind of political brouhaha that will occur as different elements try to support and oppose the normalization of US-Iran ties. More importantly Israel will underscore its red line against nuclear weaponization. Previously Iran was set to reach “breakout” capability of uranium enrichment – a point at which it has enough fissile material to produce a nuclear device – as early as May. Due to sabotage at the Natanz facility the breakout period may have been pushed back to July.3 This compounds the significance of this summer as a deadline for negotiating a reduction in tensions. While the US may be prepared to fudge on Iran’s breakout capabilities, Israel will not, which means a market-relevant showdown should occur this summer before Israel backs down for fear of alienating the United States. Tit-for-tat attacks in May and June could cause negative surprises for oil supply. Then there will be a mad dash by the negotiators to agree to deal before the de facto August deadline, when Iran inaugurates a new president and it becomes much harder to resolve outstanding issues. Chart 6Iran Deal Priced Into Oil Markets? Iran Deal Priced Into Oil Markets? Iran Deal Priced Into Oil Markets? Hence our argument that geopolitics adds upside risk to oil prices in the first half of the year but downside risk in the second half. The market’s expectations seem already to account for this, based on the forward curve for Brent crude oil. The marginal impact of a reconstituted Iran nuclear deal on oil prices is slightly negative over the long run since a deal is more likely to be concluded than not and will open up Iran’s economy and oil exports to the world. However, our Commodity & Energy Strategy expects the Brent price to exceed expectations in the coming years, judging by supply and demand balances and global macro fundamentals (Chart 6). If an Iran deal becomes a fait accompli in July and August the Saudis could abandon their commitment to OPEC 2.0’s production discipline. The Russians and Saudis are not eager to return to a market share war after what happened in March 2020 but we cannot rule it out in the face of Iranian production. Thus we expect oil to be volatile. Oil producers also face the threat of green energy and US shale production which gives them more than one reason to keep up production and prevent prices from getting too lofty. Throughout the post-2015 geopolitical saga between the US and Iran, major incidents have caused an increase in the oil-to-gold ratio. The risk of oil supply disruption affected the price more than the flight to gold due to geopolitical or war risk. The trend generally corresponds with that of the copper-to-gold ratio, though copper-to-gold rose higher when growth boomed and oil outperformed when US-Iran tensions spiked in 2019. Today the copper-to-gold ratio is vastly outperforming the oil-to-gold on the back of the global recovery (Chart 7). This makes sense from the point of view of the likelihood of a US-Iran deal this year. But tensions prior to a deal will push up oil-to-gold in the near term. Chart 7Biden Passes Iran Test? Likely But Not A Done Deal Biden Passes Iran Test? Likely But Not A Done Deal Biden Passes Iran Test? Likely But Not A Done Deal Bottom Line: The US-Iran diplomacy is on track. This means geopolitical risk will escalate in May and June before a short-term or interim deal is agreed in July or August. Geopolitical risk stemming from US-Iran relations will subside thereafter, unless the deadline is missed. The forward curve has largely priced in the oil price downside except for the risk that OPEC 2.0 becomes dysfunctional again. We expect upside price surprises in the near term. Biden, China, And Our Australia GeoRisk Indicator Ostensibly the US and Russia are avoiding a war over Ukraine and the US and Iran are negotiating a return to the 2015 nuclear deal. Only US-China relations utterly lack clarity, with military maneuvering in the Taiwan Strait and South China Sea and tensions simmering over the gamut of other disputes. Chart 8Biden Still Faces China Test Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) The latest data on global military spending show not only that the US and China continue to build up their militaries but also that all of the regional allies – including Japan! – are bulking up defense spending (Chart 8). This is a substantial confirmation of the secular growth of geopolitical risk, specifically in reaction to China’s rise and US-China competition. The first round of US-China talks under Biden went awry but since then a basis has been laid for cooperation on climate change, with President Xi Jinping attending Biden’s virtual climate change summit (albeit with no bilateral summit between the two). If John Kerry is removed as climate czar over his Iranian controversy it will not have an impact other than to undermine American negotiators’ reliability. The deeper point is that climate is a narrow basis for US-China cooperation and it cannot remotely salvage the relationship if a broader strategic de-escalation is not agreed. Carbon emissions are more likely to become a cudgel with which the US and West pressure China to reform its economy faster. The Department of Defense is not slated to finish its comprehensive review of China policy until June but most US government departments are undertaking their own reviews and some of the conclusions will trickle out in May, whether through Washington’s actions or leaks to the press. Beijing could also take actions that upend the Biden administration’s assessment, such as with the Microsoft hack exposed earlier this year. The Biden administration will soon reveal more about how it intends to handle export controls and sanctions on China. For example, by May 19 the administration is slated to release a licensing process for companies concerned about US export controls on tech trade with China due to the Commerce Department’s interim rule on info tech supply chains. The Biden administration looks to be generally hawkish on China, a view that is now consensus. Any loosening of punitive measures would be a positive surprise for Chinese stocks and financial markets in general. There are other indications that China’s relationship with the West is not about to improve substantially – namely Australia. Australia has become a bellwether of China’s relations with the world. While the US’s defense commitments might be questionable with regard to some of China’s neighbors – namely Taiwan (Province of China) but also possibly South Korea and the Philippines – there can be little doubt that Australia, like Japan, is the US’s red line in the Pacific. Australian politics have been roiled over the past several years by the revelation of Chinese influence operations, state- or military-linked investments in Australia, and propaganda campaigns. A trade war erupted last year when Australia called for an investigation into the origins of COVID-19 and China’s handling of it. Most recently, Victoria state severed ties with China’s Belt and Road Initiative. Despite the rise in Sino-Australian tensions, the economic relationship remains intact. China’s stimulus overweighed the impact of its punitive trade measures against Australia, both by bidding up commodity prices and keeping the bulk of Australia’s exports flowing (Chart 9). As much as China might wish to decouple from Australia, it cannot do so as long as it needs to maintain minimum growth rates for the sake of social stability and these growth rates require resources that Australia provides. For example, global iron ore production excluding Australia only makes up 80% of China’s total iron ore imports, which necessitates an ongoing dependency here (Chart 10). Brazil cannot make up the difference. Chart 9China-Australia Trade Amid Tensions China-Australia Trade Amid Tensions China-Australia Trade Amid Tensions Chart 10China Cannot Replace Australia China Cannot Replace Australia China Cannot Replace Australia This resource dependency does not necessarily reduce geopolitical tension, however, because it increases China’s supply insecurity and vulnerability to the US alliance. The US under Biden explicitly aims to restore its alliances and confront autocratic regimes. This puts Australia at the front lines of an open-ended global conflict. Chart 11Introducing: Australia GeoRisk Indicator (Smoothed) Introducing: Australia GeoRisk Indicator (Smoothed) Introducing: Australia GeoRisk Indicator (Smoothed) Our newly devised Australia GeoRisk Indicator illustrates the point well, as it has continued surging since the trade war with China first broke out last year (Chart 11). This indicator is based on the Australian dollar and its deviation from underlying macro variables that should determine its course. These variables are described in Appendix 1. If the Aussie weakens relative to these variables, then an Australian-specific risk premium is apparent. We ascribe that premium to politics and geopolitics writ large. A close examination of the risk indicator’s performance shows that it tracks well with Australia’s recent political history (Chart 12). Previous peaks in risk occurred when President Trump rose to power and Australia, like Canada, found itself beset by negative pressures from both the US and China. In particular, Trump threatened tariffs and the Australian government banned China’s Huawei from its 5G network. Today the rise in geopolitical risk stems almost exclusively from China. There is potential for it to roll over if Biden negotiates a reduction in tensions but that is a risk to our view (an upside risk for Australian and global equities). Chart 12Australian GeoRisk Indicator (Unsmoothed) Australian GeoRisk Indicator (Unsmoothed) Australian GeoRisk Indicator (Unsmoothed) What does this indicator portend for tradable Australian assets? As one would expect, Australian geopolitical risk moves inversely to the country’s equities, currency, and relative equity performance (Chart 13). Australian equities have risen on the back of global growth and the commodity boom despite the rise in geopolitical risk. But any further spike in risk could jeopardize this uptrend. Chart 13Australia Geopolitical Risk And Tradable Assets Australia Geopolitical Risk And Tradable Assets Australia Geopolitical Risk And Tradable Assets An even clearer inverse relationship emerges with the AUD-JPY exchange rate, a standard measure of risk-on / risk-off sentiment in itself. If geopolitical risk rises any further it should cause a reversal in the currency pair. Finally, Australian equities have not outperformed other developed markets excluding the US, which may be due to this elevated risk premium. Bottom Line: China is the most important of Biden’s foreign policy hurdles and unlike Russia and Iran there is no sign of a reduction in tension yet. Our Australian GeoRisk Indicator supports the point that risk remains very elevated in the near term. Moreover China’s credit deceleration is also negative for Australia. Cyclically, however, assuming that China does not overtighten policy, we take a constructive view on the Aussie and Australian equities. Biden’s Border Troubles Distract From Bullish Mexico Story The biggest criticism of Biden’s first 100 days has been his reduction in a range of enforcement measures on the southern border which has encouraged an overflow of immigrants. Customs and Border Patrol have seen a spike in “encounters” from a low point of around 17,000 in 2020 to about 170,000 today. The trend started last year but accelerated sharply after the election and had surpassed the 2019 peak of 144,000. Vice President Kamala Harris has been put in charge of managing the border crisis, both with Mexico and Central American states. She does not have much experience with foreign policy so this is her opportunity to learn on the job. She will not be able to accomplish much given that the Biden administration is unwilling to use punitive measures or deterrence and will not have large fiscal resources available for subsidizing the nations to the south. With the US economy hyper-charged, especially relative to its southern neighbors, the pace of immigration is unlikely to slacken. From a macro point of view the relevance is that the US is not substantially curtailing immigration – quite the opposite – which means that labor force growth will not deviate from its trend. What about Mexico itself? It is not likely that Harris will be able to engage on a broader range of issues with Mexico beyond immigration. As usual Mexico is beset with corruption, lawlessness, and instability. To these can be added the difficulties of the pandemic and vaccine rollout. Tourism and remittances are yet to recover. Cooperation with US federal agents against the drug cartels is deteriorating. Cartels control an estimated 40% of Mexican territory.4 Nevertheless, despite Mexico’s perennial problems, we hold a positive view on Mexican currency and risk assets. The argument rests on five points: Strong macro fundamentals: With China’s fiscal-and-credit impulse slowing sharply, and US stimulus accelerating, Mexico stands to benefit. Mexico has also run orthodox monetary and fiscal policies. It has a demographic tailwind, low wages, and low public debt. The stars are beginning to align for the country’s economy, according to our Emerging Markets Strategy. US and Canadian stimulus: The US and Canada have the second- and third-largest fiscal stimulus of all the major countries over the 2019-21 period, at 9% and 8% of GDP respectively. Mexico, with the new USMCA free trade deal in hand, will benefit. US protectionism fizzled: Even Republican senators blocked President Trump’s attempted tariffs on Mexico. Trump’s aggression resulted in the USMCA, a revised NAFTA, which both US political parties endorsed. Mexico is inured to US protectionism, at least for the short and medium term. Diversification from China: Mexico suffered the greatest opportunity cost from China’s rise as an offshore manufacturer and entrance to the World Trade Organization. Now that the US and other western countries are diversifying away from China, amid geopolitical tensions, Mexico stands to benefit. The US cannot eliminate its trade deficit due to its internal savings/investment imbalance but it can redistribute that trade deficit to countries that cannot compete with it for global hegemony. AMLO faces constraints: A risk factor stemmed from politics where a sweeping left-wing victory in 2018 threatened to introduce anti-market policies. President Andrés Manuel López Obrador (known as AMLO) and his MORENA party gained a majority in both houses of the legislature. Their coalition has a two-thirds majority in the lower house (Chart 14). However, we pointed out that AMLO’s policies have not been radical and, more importantly, that the midterm election would likely constrain his power. Chart 14Mexico’s Midterm Election Looms Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) These are all solid points but the last item faces a test in the upcoming midterm election. AMLO’s approval rating is strong, at 63%, putting him above all of his predecessors except one (Chart 15). AMLO’s approval has if anything benefited from the COVID-19 crisis despite Mexico’s inability to handle the medical challenge. He has promised to hold a referendum on his leadership in early 2022, more than halfway through his six-year term, and he is currently in good shape for that referendum. For now his popularity is helpful for his party, although he is not on the ballot in 2021 and MORENA’s support is well beneath his own. Chart 15AMLO’s Approval Fairly Strong Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) MORENA’s support is holding at a 44% rate of popular support and its momentum has slightly improved since the pandemic began. However, MORENA’s lead over other parties is not nearly as strong as it was back in 2018 (Chart 16, top panel). The combined support of the two dominant center-right parties, the Institutional Revolutionary Party and the National Action Party, is almost equal to that of MORENA. And the two center-left parties, the Democratic Revolution Party and Citizen’s Movement, are part of the opposition coalition (Chart 16, bottom panel). The pandemic and economic crisis will motivate the opposition. Chart 16MORENA’s Support Holding Up Despite COVID Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Traditionally the president’s party loses seats in the midterm election (Table 2). Circumstances are different from the US, which also exhibits this trend, because Mexico has more political parties. A loss of seats from MORENA does not necessarily favor the establishment parties. Nevertheless opinion polling shows that about 45% of voters say they would rather see MORENA’s power “checked” compared to 41% who wish to see the party go on unopposed.5 Table 2Mexican President’s Party Tends To Lose Seats In Midterm Election Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) While the ruling coalition may lose its super-majority, it is not a foregone conclusion that MORENA will lose its majority. Voters have decades of experience of the two dominant parties, both were discredited prior to 2018, and neither has recovered its reputation so quickly. The polling does not suggest that voters regret their decision to give the left wing a try. If anything recent polls slightly push against this idea. If MORENA surprises to the upside then AMLO’s capabilities would increase substantially in the second half of his term – he would have political capital and an improving economy. While the senate is not up for grabs in the midterm, MORENA has a narrow majority and controls a substantial 60% of seats when its allies are taken into account. In this scenario AMLO could pursue his attempts to increase the state’s role in key industries, like energy and power generation, at the expense of private investors. Even then the Supreme Court would continue to act as a check on the government. The 11-seat court is currently made up of five conservatives, two independents, and three liberal or left-leaning judges. A new member, Margarita Ríos Farjat, is close to the government, leaving the conservatives with a one-seat edge over the liberals and putting the two independents in the position of swing voters. Even if AMLO maintains control of the lower house, he will not be able to override the constitutional court, as he has threatened on occasion to do, without a super-majority in the senate. Bottom Line: AMLO will likely lose some ground in the lower house and thus suffer a check on his power. This will only confirm that Mexican political risk is not likely to derail positive underlying macro fundamentals. Continue to overweight Mexican equities relative to Brazilian.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix 1 The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our Australian GeoRisk Indicator (see Chart 11-12 above) uses the same simple methodology used in our other indicators, which avoid the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the AUD, and compare its movement against several fundamental factors – in this case global energy and base metal prices, global metals and mining stock prices, and the Chilean peso. Australia is a commodity-exporting country. It is the largest producer of iron ore and is among the largest producers of coal and natural gas. It is also a major trading partner for China. Due to the nature of its economy the Australian dollar moves with global metal and energy prices and the global metals and mining equity prices. Chile, another major commodity producer also moves with global metal prices, hence our inclusion of the peso in this indicator. The AUD has a high correlation with all of these assets, and if the changes in the value of the AUD lag or lead the changes in the value of these assets, the implication is that geopolitical risk unique to Australia is not priced by the market. We included the peso as Chile is not as affected as Australia by any conflict in the South China Sea or Northeast Asia, which means that a deviation of the AUD from CLP represents a unique East Asia Pacific risk. Our indicator captures the involvement of Australia in a few regional and international conflicts. The indicator climbed as Australia got involved in the East Timor emergency and declined as it exited. It continued declining even as Australia joined the US in the Afghanistan and Iraq wars, which showed that investors were unperturbed by faraway wars, while showing measurable concern in the smaller but closer Timorese conflict. Risks went up again as the nation erupted in labor protests as the Howard government made changes to the labor code. We see the market pricing higher risk again during the 2008 financial crisis, although it was modest and Australia escaped the crisis unscathed due to massive Chinese stimulus. Since then, investors have been climbing a wall of worry as they priced in Northeast Asia-related geopolitical risks. These started with the South Korean Cheonan sinking and continued with the Sino-Japanese clash over the Senkaku islands. They culminated with the Chinese ADIZ declaration in late 2013. In 2016, Australia was shocked again when Donald Trump was elected, and investor fears were evident when the details of Trump-Turnbull spat were made public. The risk indicator reached another peak during the trade wars between the US and the rest of the world. Investors were not worried about COVID-19 as Australia largely contained the pandemic, but the recent Australian-Chinese trade war pushed the risk indicator up, giving investors another wall of worry. If the Biden administration forces Australia into a democratic alliance in confrontation with autocratic China then this risk will persist for some time.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com We Read (And Liked) ... The Narrow Corridor: States, Societies, And The Fate Of Liberty This book is a sweeping review of the conditions of liberty essential to steering the world away from the Hobbesian war of all against all. In this unofficial sequel to the 2012 hit, Why Nations Fail: The Origins Of Power, Prosperity, And Poverty, Daron Acemoglu (Professor of Economics at the Massachusetts Institute of Technology) and James A. Robinson (Professor of Global Conflict Studies at the University of Chicago) further explore their thesis that the existence and effectiveness of democratic institutions account for a nation’s general success or failure. The Narrow Corridor6 examines how liberty works. It is not “natural,” not widespread, “is rare in history and is rare today.” Only in peculiar circumstances have states managed to produce free societies. States have to walk a thin line to achieve liberty, passing through what the authors describe as a “narrow corridor.” To encourage freedom, states must be strong enough to enforce laws and provide public services yet also restrained in their actions and checked by a well-organized civil society. For example, from classical history, the Athenian constitutional reforms of Cleisthenes “were helpful for strengthening the political power of Athenian citizens while also battling the cage of norms.” That cage of norms is the informal body of customs replaced by state institutions. Those norms in turn “constrained what the state could do and how far state building could go,” providing a set of checks. Though somewhat fluid in its definition, liberty, as Acemoglu and Robinson show, is expressed differently under various “leviathans,” or states. For starters, the “Shackled Leviathan” is a government dedicated to upholding the rule of law, protecting the weak against the strong, and creating the conditions for broad-based economic opportunity. Meanwhile, the “Paper Leviathan” is a bureaucratic machine favoring the privileged class, serving as both a political and economic brake on development and yielding “fear, violence, and dominance for most of its citizens.” Other examples include: The “American Leviathan” which fails to deal properly with inequality and racial oppression, two enemies of liberty; and a “Despotic Leviathan,” which commands the economy and coerces political conformity – an example from modern China. Although the book indulges in too much jargon, it is provocative and its argument is convincing. The authors say that in most places and at most times, the strong have dominated the weak and human freedom has been quashed by force or by customs and norms. Either states have been too weak to protect individuals from these threats or states have been too strong for people to protect themselves from despotism. Importantly, many states believe that once liberty is achieved, it will remain the status quo. But the authors argue that to uphold liberty, state institutions have to evolve continuously as the nature of conflicts and needs of society change. Thus society's ability to keep state and rulers accountable must intensify in tandem with the capabilities of the state. This struggle between state and society becomes self-reinforcing, inducing both to develop a richer array of capacities just to keep moving forward along the corridor. Yet this struggle also underscores the fragile nature of liberty. It is built on a precarious balance between state and society; between economic, political, and social elites and common citizens; between institutions and norms. If one side of the balance gets too strong, as has often happened in history, liberty begins to wane. The authors central thesis is that the long-run success of states depends on the balance of power between state and society. If states are too strong, you end up with a “Despotic Leviathan” that is good for short-term economic growth but brittle and unstable over the long term. If society is too strong, the “Leviathan” is absent, and societies suffer under a pre-modern war of all against all. The ideal place to be is in the narrow corridor, under a shackled Leviathan that will grow state capacity and individual liberty simultaneously, thus leading to long-term economic growth. In the asset allocation process, investors should always consider the liberty of a state and its people, if a state’s institutions grossly favor the elite or the outright population, whether these institutions are weak or overbearing on society, and whether they signify a balance between interests across the population. Whether you are investing over a short or long horizon, returns can be significantly impacted in the absence of liberty or the excesses of liberty. There should be a preference among investors toward countries that exhibit a balance of power between state and society, setting up a better long-term investment environment, than if a balance of power did not exist.   Guy Russell Research Analyst GuyR@bcaresearch.com GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Footnotes 1 "President Biden’s first 100 days as president fact-checked," BBC News, April 29, 2021, bbc.com. 2 "Oil tanker off Syrian coast hit in suspected drone attack," Al Jazeera, April 24, 2021, Aljazeera.com. 3 See Yaakov Lappin, "Natanz blast ‘likely took 5,000 centrifuges offline," Jewish News Syndicate, jns.org. 4 John Daniel Davidson, "Former US Ambassador To Mexico: Cartels Control Up To 40 Percent Of Mexican Territory," The Federalist, April 28, 2021, thefederalist.com. 5 See Alejandro Moreno, "Aprobación de AMLO se encuentra en 61% previo a campañas electorales," El Financiero, April 5, 2021, elfinanciero.com. 6 Penguin Press, New York, NY, 2019, 558 pages. Section III: Geopolitical Calendar

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Global CO2 Emissions Will Rebound Post-COVID-19 Global CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout China, India Lead Coal-Fired Generation Buildout China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing Share of Electricity From Renewables Has Been Increasing Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Renewables ESG Risks Grow With Demand Renewables ESG Risks Grow With Demand Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 OCTOBER HRC FUTURES HIT A HIGH ON THE SHFE OCTOBER HRC FUTURES HIT A HIGH ON THE SHFE Chart 9 Covid Uncertainty Could Push Up Gold Demand Covid Uncertainty Could Push Up Gold Demand   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.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