Global

Special Report

Highlights We use a correlation-hedge approach to manage emerging market (EM) currency exposure for global investors with nine different home currencies. For USD-based investors, EM debt volatility is driven by the EM spot exchange rate vs. USD. Hedged EM debt has better absolute and risk-adjusted returns than US Treasurys. Investing in EM equities, on the other hand, makes sense only when the expected absolute return is positive on a sustained basis. During these episodes, hedging is not necessary. If USD-based investors choose to manage EM currency exposure directly, then a 12-month momentum-based dynamic hedging strategy could add value in terms of risk-adjusted returns for both EM stocks and bonds. USD-based investors could also diversify the source of funding by selling closely correlated DM currencies using an overlay of currency forwards. For non-USD-based investors, EM currency volatility is low and there is no need to fully hedge EM exposure. Domestic bonds have very low volatility, therefore these investors should avoid EM debt if their objective is to maximize risk-adjusted returns. To enhance returns, unhedged EM equities are a much better choice than EM debt. Currency overlay, in line with our long-held view on the total portfolio approach, should be managed at the total fund level. Feature How to manage EM currency exposure when investing in EM local currency debt and equities has been a frequently asked question since our reports on managing developed market (DM) currency exposure when investing in DM equities 1,2 and government bonds.3 According to the BIS Triennial Central Bank Survey, EM currency exchange markets have evolved rapidly since 2001. The daily turnover reached 1.65 trillion dollars in April 2019, which is about 25% of the global currency daily turnover.4 While it is becoming increasingly easy to trade EM currencies, compared with DM currencies it is still more costly and operationally more challenging to hedge EM currency exposure, especially the currencies with non-deliverable forwards (NDFs) that require collateral management. In this report, we identify the return and volatility drivers of EM local currency government bonds (represented by JP Morgan’s GBI-EM Global Diversified Local Currency Index) and EM equities (represented by MSCI’s EM Net Return Index). We briefly touch on a momentum-based dynamic hedging strategy to hedge EM exposure directly for USD-based investors. Our main focus is to test a correlation-hedge approach, both static and dynamic, for nine home currencies: the US dollar (USD), the euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Canadian dollar (CAD), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish krona (SEK), and the Norwegian krone (NOK). We want to determine if a USD-based investor’s return/risk profile would be improved when investing in EM assets by using unfunded overlays of DM currency forwards. Finally, we present solutions for non-USD investors, which vary based on the correlations between the home currencies and the EM currency aggregates. Part 1: The USD Perspective 1.1 EM Asset Return Drivers In general, unhedged USD returns for US investors from investing in foreign assets can be decomposed into three parts as shown in the following equation (1): (1+Rd) = (1+Rh) (1+Rc) (1+Rs) ..…..(1) Where, Rd is the unhedged return in USD. Rh is the hedged return in USD using currency forwards. Rc is the carry return resulting from the short-term rate differential between a foreign country and the US. Rs is the spot exchange rate return of a foreign currency vs. the USD (quoted as how many USD per 1 unit of foreign currency). Chart 1A and Chart 1B show the return decompositions of JP Morgan’s (JPM) EM local currency government bonds and MSCI’s EM equities based on equation (1). Chart 1AEM Local Debt USD Return Decomposition Chart 1BEM Equities USD Return Decomposition Hedging reduces both the volatility and returns for both EM local currency bonds and equities; however, the return and volatility reductions are more significant in bonds than in stocks (panel 1 in Chart 1A and Chart 1B). EM currency aggregate indexes implied from JPM and MSCI are different because of the different country compositions. The currency component has been very volatile for both indexes and has generated negative returns during the 18 years from January 2003 to January 2021 (panel 3 in Chart 1A and Chart 1B). The carry component from JPM is sharply higher than that from MSCI, which is also the result of different country compositions (panel 2, Chart 1A and Chart 1B). The carry components from both indexes have very low volatility with positive returns over the 18-year period. Many EM countries had much higher interest rates than the US, therefore a US investor had to be exposed to EM currencies to capture this carry gain. Thus, from a return-enhancing perspective, an investor should hedge only if he/she expects the EM currency spot exchange rate to depreciate more than the implied carry (panel 3, Chart 1A and Chart 1B). The answer may be different from a volatility-reducing perspective, especially for EM debt where currency volatility dominates bond volatility. We plot the return-risk profiles of EM local currency bonds and equities (hedged and unhedged) in Charts 2A, 2B and 2C to show how they behave in different environments compared to US equities, US Treasurys and hedged non-US global government bonds. Table 1 further lists the detailed statistics of all the above-mentioned assets, in addition to the spot currency and carry components implied from JPM’s EM local currency bond index and MSCI’s EM index, ranked by risk-adjusted return. The entire 18-year period (Chart 2A) is also separated into the period with steadily rising EM currencies (1/2003 – 7/2008, Chart 2B) and the period with declining EM currencies (8/2008-1/2021, Chart 2C). Chart 2AUSD Asset Return-Risk Profile For The Entire Period (1/2003-1/2021) Chart 2BUSD Asset Return-Risk Profile When EM Currencies Were Strong (1/2003-7/2008) Chart 2CUSD Asset Return-Risk Profile When EM Currencies Were Weak (8/2008-1/2021) Both EM debt and equities had impressive unhedged returns in the period from January 2003 to July 2008 when the EM currency index rose steadily against the USD. Even on a hedged basis, EM bonds still delivered better absolute returns (5.1%) than US Treasurys (4.3%) with lower volatility. In terms of EM equities, although hedged return of 22.8% significantly outpaced US equities (9.7%), the volatility of EM equities (16.8%) was much higher than US equities (9.8%). Interestingly, in the period with declining EM FX from August 2008 to January 2021, hedged EM equities (5.6%) significantly underperformed US equities (11.5%) with comparable volatility, but hedged EM bonds (4.2%) outperformed US Treasurys (3.6%) with comparable volatility, despite the negative carry. It is easy to make the case for EM equities: US investors should not touch EM equities unless they are convinced that EM is entering a sustainably strong absolute return period. There is no need to hedge the currency exposure because the risk reduction is relatively small. In the case of EM local currency debt, the three components of total returns in USD based on equation (1) have distinct characteristics as follows: First, the carry component generated an annualized return of 3.4% with only 0.7% volatility in the entire period, making it the best performer among all the assets in terms of risk-adjusted return, as shown in Table 1. Table 1USD Asset Return-Risk Profile In Different Time Periods Chart 3What Drives The Hedged Return Of EM Local Debt? Second, the hedged return or the EM duration return (i.e. the compensation for a US investor to take on EM interest rate and term premia risks), had a better return/risk profile than US Treasurys in terms of both absolute return and risk-adjusted return, regardless of whether the EM currency index rose or fell against the USD. From January 2003 to January 2021, hedged EM debt returned 4.5% with a volatility of 4.1%, giving a 1.1 return per unit of risk, while US Treasurys returned 3.8% with a volatility of 4.3%, resulting in a 0.9 return per unit of risk. This component is mainly driven by the direction of government bonds in the developed markets as shown in Chart 3. Third, from January 2003 to January 2021, the JPM-implied EM currency had the worst return/risk profile with an annualized loss of 1.7% and annualized volatility of 9.1% (Table 1). However, this component was also the most regime-dependent. Between January 2003 and July 2008 it registered an annualized gain of 7.0% and an annualized volatility of 6.2%, in contrast with the annualized loss of 5.2% and annualized volatility of 9.9% from August 2008 to January 2021. Historically, the EM currency as an aggregate, no matter how the aggregate is calculated, closely correlates to commodities as shown in Chart 4. This is because many EM countries are either commodity producers or have significant trading exposure to China, the dominant player influencing commodity prices as shown in Chart 5. Chart 4EM FX Largely Driven By Commodities Chart 5The Commodities-China Link It is a challenge to build a systematic EM currency model due to the complex nature of EM economies. BCA’s FX Strategy team is working on EM currency models by applying the same approach they used for their DM models. BCA’s EMS Strategy team takes a more discretionary approach to forecasting currencies. Below we will explore two options: one for investors who choose to manage an EM FX hedging program directly and another for investors who cannot manage a direct EM currency hedging program but want to improve their return-risk profile in EM assets. 1.2 Momentum-Based Dynamic Hedging Of EM Currencies Price momentum is a useful tool for dynamic hedging as shown in our previous work on DM currency exposure management. A simple rule of hedging back to the home currency when the 12-month price momentum of a foreign currency turns negative adds value for investors with several DM home currencies. Given that the USD is a strong momentum currency, it makes sense to test if a simple 12-month price momentum rule for the EM FX aggregate vs. USD adds any value. The results are encouraging as shown in Chart 6A and Chart 6B and Chart 7A and Chart 7B. Chart 6AMomentum-Based Dynamic Hedging For EM Bonds Chart 6BMomentum-Based Dynamic Hedging For EM Stocks In the case of EM local debt, dynamic hedging reduced volatility to 8.4% from an unhedged volatility of 11.7%, while only trimming return slightly compared with the unhedged index (Charts 6A, 7A). For EM equities, dynamic hedging cut volatility to 18.6% from the unhedged volatility of 21.1%, while increasing the return by 25 bps, compared to the unhedged index. (Charts 6B, 7B). Chart 7AEM Local Debt Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** Chart 7BEM Equities Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** These results are directionally encouraging, but this method still requires hedging all EM currencies. The approach may operationally challenge investors who are not equipped to manage EM currency overlays. Bottom Line: Using only price momentum to hedge EM currency aggregates could improve the return-risk profile of both EM debt and equities, even though the improvements would be limited. This is encouraging for our eventual systematic approach for direct EM currency hedging. 1.3 Correlation Hedge Using DM Currencies EM FX is closely correlated with DM commodity currencies, such as the NOK, CAD, AUD, and NZD. As shown in Charts 8A and 8B, even the euro has an average correlation greater than 60% with EM currency aggregates. Only the JPY has an unstable correlation with the EM currencies of less than 25%, while the GBP also has a relative lower correlation. Chart 8AJPM-Implied EM FX* Correlation** With DM FX Chart 8BMSCI-Implied EM FX* Correlation** With DM FX Therefore, a USD-based investor, instead of hedging out EM currency exposure directly, should be able to eliminate part of EM currency volatility by selling lower-yielding DM currencies. This move would diversify his/her source of funding from USD to other DM currencies with high correlations with EM currencies. To test the effect on the return-risk profile, we use an unfunded overlay of 1-month DM currency forwards and rebalance monthly. To begin, we test a static correlation hedge where each of the eight DM currencies is sold individually. Then we test a dynamic correlation hedge where each one is dynamically sold based on the BCA Forex Strategy Team’s Intermediate-Term Timing Model (ITTM), which uses the same indicators described in our DM currency hedging report. To avoid subjective selection bias among the currencies, we also test an equally- weighted basket of eight currencies (AUD, NZD, JPY, GBP, EUR, CAD, NOK, and SEK) for dynamic hedging and an equally- weighted basket of five currencies (GBP, EUR, CAD, NOK, and SEK) for static hedging. The AUD, NZD, and JPY were excluded in the static hedging basket because in general, AUD and NZD had very high carries and JPY had an unstable correlation with EM currencies. The combined results are shown in Chart 9A and Chart 9B. Additionally, Table 2A and Table 2B list the return-risk profiles together with the fully hedged and unhedged EM indexes for equities and local debt. Chart 9AStatic Correlation Hedge For US Investors Chart 9BDynamic Correlation Hedge For US Investors Table 2AEM Debt Funding Source Diversification For USD-Based Investors (2/2003-1/2021) Table 2BEM Equity Funding Source Diversification For USD-Based Investors (2/2003-1/2021) For US investors investing in EM local currency bonds, the best risk-adjusted return of 1.08 would come from fully hedging all the EM currencies as shown in Table 2A. Fully-hedged EM debt has the lowest volatility (4.12%), but also the lowest return (4.45%). To achieve a comparable return of unhedged EM debt (6.18%) without incurring the same high volatility (11.71%), however, a USD-based investor could either statically sell the five DM currencies or dynamically sell the eight DM currencies. The resulting risk-adjusted return of 0.8 would still be comparable to US Treasurys as shown in Table 1. US investors investing in EM equities may improve their return-risk profile by funding their positions in DM currencies. If the aim is to maximize risk-adjusted returns, then the choice would be to fund the position by selling the basket of equally weighted five DM currencies using currency forwards (i.e. using a static correlation hedge). In this way, they would achieve a comparable volatility (16.25%) as if all the EM currencies were fully hedged to USD (16.29%), while also achieving a higher return (12.29%) than when all the EM currencies were not hedged (11.71%). The return per unit of risk of 0.76 would be the highest among all the cases as shown in Table 2B and be on par with US equities as shown in Table 1. If investors prefer even higher returns without significantly higher volatility, then dynamically selling an equally weighted basket of eight currencies would achieve an annualized return of 13.03% with a higher volatility of 18.71%, resulting in a risk-adjusted return of 0.7. Bottom Line: USD-based asset allocators should use the hedged EM debt index and the unhedged EM equities index as benchmarks to measure the performance of their asset-class managers. The EM currency exposure should be managed in a currency overlay at the total fund level by either statically or dynamically selling DM currencies using a correlation hedge, depending on the return-risk preferences. Part 2: Non-USD-Perspective Six out of the eight non-USD DM currencies have strong positive correlations with EM currencies as shown in Chart 8A and Chart 8B. Therefore, non-USD investors investing in EM assets should naturally experience less spot-currency volatility (Chart 10A and Chart 10B). Consequently, they do not need to hedge EM currency exposure from a volatility perspective. But what about return enhancement? Should they consider an allocation to EM assets in place of domestic assets? If they do, would the correlation-hedge approach used by USD-based investors benefit them too? Chart 10ADM Currency Per Unit Of EM Currency Chart 10BDM Currency Per Unit Of EM Currency To find answers to those questions, we compare the return-risk profiles of domestic assets, unhedged EM assets, and correlation-hedged EM assets in Table 3A and Table 3B. For the correlation-hedged results for non-USD investors, we simply use the results for the US investors converted into the non-USD home currencies at spot exchange rates. This way, the return enhancements from the correlation-hedged EM assets compared to the unhedged EM assets would be similar for all nine currencies. Chart 3AEM-Debt* For Non USD-Based Investors Table 3BEM-Stocks* For Non USD-Based Investors We find that non-USD investors would do better to avoid local-currency EM debt if their objective is to maximize risk-adjusted returns because domestic government bonds had unbeatably low volatility, resulting in the highest risk-adjusted returns, as shown in Table 3A. But domestic government bonds had lower returns than unhedged EM bonds for all but AUD- and NZD-based investors. To further enhance the return-risk profile, non-USD investors could follow their US counterparts by dynamically diversifying their funding sources, then converting their USD returns into their home currency at spot exchange rates (i.e. not hedging the USD exposure). GBP- and JPY-based investors would benefit the most from a dynamic correlation hedge with higher returns and lower volatility compared with the unhedged case. In the case of EM equities, other than SEK- and NZD-based investors, unhedged EM equities have higher returns on an absolute and risk-adjusted basis compared with domestic equities, with GBP-, JPY- and euro-based investors benefiting the most (Table 3B). Even though NOK-based investors increased their returns by only 1% by putting funds into unhedged EM equities, they enjoy lower volatility than in domestic equities. Unlike the case for EM debt where a static correlation hedge did not improve over an unhedged case, both static and dynamic correlation hedges improve the return/risk profiles relative to the unhedged case, and the dynamic hedge outperforms the static hedge in each country. While domestic equities underperform domestic government bonds in terms of risk-adjusted returns, EM equities outperform EM local currency debt when a dynamic correlation hedge is applied. Even in the unhedged case, EM equities are still a much better choice than EM debt (Chart 11). To evaluate how this could impact an asset allocation, we replace home equity with EM equities in a 60/40 home equity/Treasury portfolio. In this extreme exercise, six of the eight non-USD-based portfolios could generate better return/risk profiles, with only the NZD- and SEK-based portfolios worse off (Chart 12). Chart 11Risk-Adjusted Return: Stocks Minus Bonds Chart 12Asset Allocation Implications*     Bottom Line: Non-USD-based investors should avoid EM local debt if their objective is to maximize their risk-adjusted returns. For the purposes of return enhancement, EM equities are a much better choice than EM debt for all investors with the exception of those based in New Zealand and Sweden.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1,2Please see Global Asset Allocation Special Reports, “Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors,” dated September 29, 2017; and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)," dated October 13, 2017. 3 Please see Global Asset Allocation Special Reports, “Why Invest In Foreign Government Bonds?” dated March 12, 2018. 4 Please see "Triennial Central Bank Survey Foreign exchange turnover in April 2019," Bank for International Settlements, dated 16 September 2019.

Special Report

Highlights OPEC 2.0’s production-management strategy and physical supply deficits in base metals will keep growth in demand above that of supply into 2022 (Chart of the Week). Over the next decade, markets will have to reconcile sustaining oil and gas supplies during the low-carbon transition and incentivizing investment in metals used in renewable energy grids. Electric vehicle sales will rise, particularly in China, which has built a commanding position in global EV supply chains. This supports China’s goal of reducing dependence on imported oil, but increases supply-chain concentration risk ex-China. Investors will expect sustainable returns from energy and metals producers and lower CO2 emissions. Otherwise, capital markets will remain parsimonious and investment will be delayed. This will increase price volatility. The investment required to transition to renewables almost surely will result in higher oil and metals prices. If this transition increases CO2, GHGs and atmospheric particulates, producers will confront more regulation and higher costs. Differing supply-demand drivers in oil and metals will result in separate, asynchronous bull markets for each, not a global commodity super-cycle. Successful technology work-arounds – e.g., carbon capture, use and storage – would keep oil and gas competitive, provided the sector can attract funding. Feature Happy families are all alike; every unhappy family is unhappy in its own way. Leo Tolstoy, Anna Karenina   Every commodity market is different in its own way. Over the short term – to the end of 2022 – oil and base metals will appear to be in the early stages of a commodity super-cycle. But, upon closer examination, it is apparent the fundamental drivers for each are, and will remain, different. These markets are entering asynchronous bull markets driven by different fundamentals. The key driver of these cycles is the demand side: Oil demand will rise slightly or remain flat to declining over the next decade, while base metals demand will be rising as a function of actual spending on renewables and EVs. This means the supply side in oil and metals will have entirely different demand expectations to plan for when allocating capex going forward. Chart of the WeekDemand Will Recover Faster Than Supply Chart 2OPEC 2.0 Production Management Keeps Level Of Demand Above Supply Oil markets will be in physical deficits this year and next by design over the next couple of years, with the level of supply maintained below that of demand. This is the result of a deliberate strategy by OPEC 2.0, the producer coalition formed in late 2016 following the disastrous market-share war launched by the old OPEC cartel in 2014 (Chart 2).1 Metals markets – particularly copper and aluminum, which are critical for the transition to renewable generation – likely will be in physical deficits this year and next as well, with the level of demand above that of supply. Copper demand was exceptionally strong in the wake of a construction boom in China last year, which drew inventories from around the world (Chart 3).2 Aluminum demand in China also moved higher last year and likely will continue this year (Chart 4). We expect the global recovery this year ex-China to pick up the slack resulting from a slowdown in China in 2H21, which will keep these markets tight. Chart 3Copper Will Be In Physical Deficit... Chart 4...As Will Aluminum As the decade progresses, oil and base metals fundamentals will continue to diverge, becoming increasingly different it their own ways. Asynchronous Bull Markets: Oil First Oil demand’s rate of growth will slow as the decade progresses, but we believe OPEC 2.0’s production management strategy will continue to keep supply at a level that supports a Brent crude oil price range that accommodates both Saudi and Russian goals. Saudi Arabia’s preferred price range for Brent crude oil is, we believe, in a range of $70-$75/bbl, which allows the Kingdom to fund its diversification away from oil exports as the dominant source of GDP growth. Russia's goal is to keep price incentives for US shale producers at a minimum. Its ideal price range is between $50-$55/bbl. Neither the Kingdom of Saudi Arabia (KSA) nor Russia benefits from launching another internecine price war. Both states have endured repeated policy-induced shocks – e.g., the imposition of sanctions on Iranian crude oil exports in 2018, which was followed by waivers to Iran’s eight largest importers just before this export ban went into effect, then removed the waivers – and the pandemic demand shock this past year. Neither do they benefit from pushing Brent prices too far above $75/bbl over the next couple of years, given the fragile state of the global economy. Besides putting a dent in demand, it also would incentivize US shale production, which can ramp quickly, or encourage EV sales. This could even encourage a push to find alternatives in a market where supply chains for battery materials – chiefly cobalt and graphite – and copper are dominated by China. OPEC 2.0’s preferred range likely will be widened out to $65-$80/bbl for Brent by 2025. Given the trajectory we expect for global demand – global demand returns to pre-COVID-19 levels in 2023 – OPEC 2.0 should be able to continue with its strategy until 2024-25, making use of its spare capacity and low-cost production (Chart 5). Our demand estimates are driven by GDP estimates from the World Bank and the IMF, and we assume, at least until 2025, OPEC 2.0 will maintain its level of supply just below the level required to completely offset demand, to keep inventories from registering another round of unintended growth. This will, per the OPEC 2.0 strategy we believe is in place, keep the forward Brent curve – and by extension the WTI and other benchmark forward curves – in backwardation, which will limit the level at which producers outside the coalition can hedge forward revenues. We do not believe OPEC 2.0 wants to aggressively invest in increasing crude-oil production capacity, given the diversification goals of its core producers – i.e., those states capable of actually maintaining current production levels and increasing them if needs be.3 Chart 5OPEC 2.0 Will Match Production To Consumption Beyond 2025 and out to 2030, the supply side of the oil market becomes more cloudy. We believe core-OPEC 2.0 will be able to source capital without significant constraint, unlike the US shale producers at present. However, core-OPEC 2.0 alone cannot keep the market balanced out of its production alone, nor does it wish to launch 20- to 30-year projects when it becomes more uncertain by the year how much oil and gas is going to be needed by the market once renewables kick into high gear. OPEC 2.0 will need the US shales to increase production, along with Canada, Brazil and the North Sea, once it has exhausted its spare capacity and low-cost production that is readily available. At that point, availability of capital becomes critical, particularly following the capex reductions in the wake of the OPEC market-share war from 2014-16, the Trump waivers, and the short-lived market-share war launched by Russia in March 2020, following the breakdown of OPEC 2.0 negotiations last year to extend production cuts. The International Energy Forum (IEF), a transnational study group headquartered in Riyadh comprised of representatives from energy producer and consumer states, released a report in December showing global oil and gas capex fell 34% y/y in 2020 (Chart 6), and likely will fall another 20% in 2021 to ~ $200 billion (Chart 7). By 2030, the IEF estimates an additional $225 billion will be required in capex -- in addition to its previous estimate of close to $300 billion by then -- “to stave off a crisis.” If capital remains scarce, oil-price volatility will increase as supply growth contracts and prices move higher. At that point, prices will not be moving sharply higher per OPEC 2.0's production-management strategy. Chart 6Oil + Gas Capex Collapses In COVID-19’s Wake Chart 7Global Oil + Gas Capex Will Require A Sharp Boost By 2030 Base Metals’ Decade Spending on renewable energy last year was ~ $700 billion, according to the IEA.4 This could go to $3.4 trillion by 2030, of which $2.7 trillion could be spent on solar and wind power.5 The growth in solar and wind will require sharply higher volumes of tradeable metals important to investors, i.e., aluminum, copper, and nickel (Charts 8 & ​​​​​​9). Chart 8Solar Investment Will Soar… Chart 9…Along With Investment In Wind Energy Aluminum and copper will account for ~ 85% and 11% of solar inputs respectively; iron will account for close to 85% of wind inputs (mostly the towers), with copper making up more than 4%; nickel will account for almost 60% of inputs into new geothermal renewable generation, according to the World Bank.6 The other big slug of base metals demand comes from EVs. A battery-powered EV can contain more than 180 pounds of copper vs up to 50 pounds for conventional autos. By 2030, the demand from EVs alone would amount to close to 4mm tons of copper per year, if demand for these vehicles grows in line with the IEA’s aspirational goals (44mm units/yr). Even if that growth is delayed, this still is a significant share of total demand in a market that consumes ~ 26mm tons/yr. Nickel demand also will surge if EV demand grows in line with IEA projections. By 2040, nickel-intensive battery technology could lift demand by close to 300%, to 2.6mm tons, according to Roskill Information Services. By 2050, nickel demand could increase by as much as 3.7mm tons (Chart 10).7 Chart 10Nickel Demand Could Rise Parabolically Bull Markets, But Not A Super-Cycle … Yet It is true oil and base metals markets are tight, and likely will get tighter over the next couple of years. As the global economy recovers from the COVID-19 pandemic, demand for these commodities will rise, and supply will be constrained. However, it is important to note the supply-side constraints are idiosyncratic – different in their own ways: Oil supply will remain tight as a consequence of OPEC 2.0’s production-management strategy. Base metals – particularly copper and aluminum – will be tight owing to actual supply constraints in the face of strong demand. Over the course of the next decade, we will see asynchronous bull markets for each, not a global commodity super-cycle. Oil will behave like a commodity in its sunset phase, regardless of whether that is true: Firms in the industry are turning toward renewables and away from oil (e.g., Shell and BP). Base metals, because of their criticality to renewables and EVs, will behave like a commodities in their early-growth phase. The evolution of base metals demand as renewables and EV demand increases is difficult to estimate without solid metrics re spending, output goals and timelines. Of course, higher metals output will require higher capex to meet increasing demand for renewable energy and EVs. Just how much output will have to rise is completely unclear: Governments have yet to fully specify their goals or the budgets that will be supporting renewables demand. Whether EV demand meets the IEA’s aspirational goals is anyone’s guess, particularly as the concentration risk in the EV battery supply chain remains acute. The Biden administration appears poised to direct significant investment to reducing US exposure to battery supply chains’ concentration risks – e.g., ~ 80% of EV batteries supply chains are controlled by China – and other exposures.8 Oil output will require higher capex to maintain production to the point where it can meet declining demand. Successful technology work-arounds – e.g., carbon capture, use and storage – would keep oil and gas competitive, provided they attract funding. Bottom Line: The investment required to transition to renewables almost surely will result in higher oil and metals prices. If this transition increases CO2, GHGs and atmospheric particulates, producers will confront more regulation and higher costs. We remain bullish and retain our exposure to oil and base metals. While our recommendations are meant to be strategic, managing these exposures will require tactical agility.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1    Please see Oil Markets Steady, Despite Weather; Brent Forecast Back At $65/bbl For 2021, published 18 February 2021, for additional discussion of OPEC 2.0’s production-management strategy. It is available at ces.bcaresearch.com. 2    Please see Copper Surge Welcomes Metal Ox Year, which we published 11 February 2021. 3    These core producers, in our estimation, are KSA, Russia, Kazakhstan, Kuwait and the UAE. Others like Nigeria, Iraq and Libya are capable of increasing production, but their output is volatile. The other member states either are managing to a flat or declining profile. 4    Please see World Energy Investment 2020 (p. 8), published by the IEA in 27 May 2020. 5    Please see $3.40 Trillion to be Invested Globally in Renewable Energy by 2030, Finds Frost & Sullivan. 6    Please see our 26 November 2020 report entitled Renewables, China's FYP Underpin Metals Demand for further discussion. 7    Please see Nickel's Decade-Long Rally Is Underway, which we published last week. It is available at ces.bcaresearch.com. 8    Please see Nickel, cobalt price: 10 charts show China’s grip on battery supply chain to last decades published by mining.com 26 February 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Dear Client, In addition to this week’s abbreviated report, we are sending you a Special Report on Bitcoin. I don’t recommend you buy it. Best regards, Peter Berezin Highlights Real government bond yields have increased in recent weeks, which could put further downward pressure on equity prices in the near term. Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. Historically, rising real yields have been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Investors should favor cyclical and value-oriented stocks over defensive and growth-geared plays. Higher Real Yields: A Near-Term Risk For Stocks Chart 1Government Bond Yields Have Increased Since Bottoming Last Year Bond yields have jumped in recent weeks. After bottoming at 0.52% in August, the US 10-year Treasury yield has climbed to 1.54%, up from 0.93% at the beginning of the year. Government bond yields in the other major economies have also risen (Chart 1). While inflation expectations have bounced, the most recent increase in yields has been concentrated in the real component of bond yields (Chart 2). Optimism about a vaccine-led global growth recovery, reinforced by continued fiscal stimulus – especially in the US – has prompted investors to move forward their expectations of how soon and how high policy rates will rise (Chart 3). Chart 2AThe Real Component Has Fueled The Most Recent Rise In Bond Yields (I) Chart 2BThe Real Component Has Fueled The Most Recent Rise In Bond Yields (II) How menacing is the increase in bond yields to stock market investors? Chart 4 shows that there has been a close correlation between real yields and the forward P/E ratio at which the S&P 500 trades. The 5-year/5-year forward real yield, in particular, has moved up sharply, which could put further downward pressure on stocks in the near term. Chart 3Path Of Expected Policy Rates Being Revised Upwards Chart 4Rise In Real Rates Is A Headwind For Equity Valuations Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. As we pointed out two weeks ago, rising real yields have historically been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. In his testimony to Congress this week, Jay Powell downplayed inflation risks, stressing that the US economy was “a long way” from the Fed’s goals. He pledged to tread “carefully and patiently” and give “a lot of advance warning” before beginning the process of normalizing monetary policy. We expect the 10-year Treasury yield to stabilize in the 1.6%-to-1.7% range, still well below the level that would threaten the health of the economy. Favor Cyclical And Value-Oriented Stocks In  A Weaker Dollar Environment The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with US trading partners (Chart 5). Since the Fed is unlikely to tighten monetary policy anytime soon, US short-term real rates could fall further as inflation rises.  Chart 5The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials Chart 6Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar   Cyclical stocks, which are overrepresented outside the US, tend to benefit the most from strengthening global growth and a weakening dollar (Chart 6). Value stocks also generally do well in a weak dollar-strong growth environment (Chart 7). Moreover, bank shares – which are concentrated in value indices – typically outperform when long-term bond yields are rising (Chart 8). Chart 7AA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) Chart 7BA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II)     Chart 8Bank Shares Typically Excel When Long-Term Bond Yields Are Rising In contrast, as relatively long-duration assets, growth stocks often struggle when bond yields go up. The same is true for more speculative plays such as cryptocurrencies. In this week’s Special Report, we discuss the fate of Bitcoin, arguing that investors should resist buying it.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com     Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Highlights The price of Bitcoin has surged this year as the digital currency has gained increasing acceptance. Just as was the case with gold, a global financial system built around Bitcoin would be precariously unstable. Bitcoin transactions are expensive to make and slow to execute, making the currency unsuitable as a medium of exchange. Bitcoin miners consume more energy than many countries. ESG funds are likely to shun companies that associate themselves with the currency. Governments, which stand to lose billions of dollars in seigniorage revenue, will put up more obstacles to Bitcoin. As a result, Bitcoin will lose most of its value over time. Bitcoin And Bullion: Back To The Future? Modern banks grew out of the activity of goldsmith guilds during the Middle Ages. Not only did goldsmiths craft beautiful items from precious metals, but because they had to maintain adequate security, they also tended to offer safekeeping services. Chart 1An Inelastic Money Supply Historically Led To More Banking Crises A wealthy merchant who deposited some gold coins with a goldsmith would receive a receipt validating his claim on the coins. Rather than rushing back to the goldsmith to withdraw some coins in order to make a purchase, it became common practice to offer the receipt instead. To facilitate commerce, goldsmiths began to offer receipts for specific values, marking the creation of the first proto-banknotes. On a typical day, only a small fraction of the gold held on deposit would be withdrawn. As long as goldsmiths always had enough gold on hand to meet demand, they could issue notes in excess of the amount of gold that they held in their vaults. Sometimes the goldsmiths would use those additional notes to purchase goods for themselves. Other times, they would lend out the notes, with interest charged to the borrower. The fractional reserve banking system was born. As the fledgling banking system evolved, it became more sophisticated. Nevertheless, it continued to suffer from a fundamental flaw: It was highly vulnerable to self-fulfilling crises. If people began to fear that a bank would run out of gold reserves, they would rush to the bank to be the first to withdraw their funds. Chart 1 shows that bank runs were very common during the 19th century. What Is Bitcoin Good For? Not Much When Bitcoin enthusiasts talk about a world in which global finance is centred on cryptocurrencies, they see the future. Personally, I see the past. John Maynard Keynes famously called the gold standard a barbarous relic. He had a point. A world based on the “Bitcoin standard” would be just as chaotic as the one that was built on the gold standard. Bitcoin’s defenders would argue that the digital currency has advantages that gold, and more importantly, fiat money do not have. But what exactly are those advantages? It certainly is not ease of use. Whereas the Visa network processes nearly 25,000 transactions per second, the Bitcoin mempool, the pool of unconfirmed transactions, has trouble handling five (Chart 2). Bitcoin transactions take 10 minutes to an hour to complete compared to just a few seconds for most debit or credit cards. The average fee for a Bitcoin transaction is around $30 – a number that has been rising over the past year (Chart 3). Chart 2Bitcoin: The Speed Of Transactions, Or Lack Of It Chart 3Bitcoin: The Cost Per Transaction Is Rising Crypto-optimists insist that these impediments will recede over time. However, this is far from certain. Efforts to expedite Bitcoin transactions have run into “fundamental issues.” Markus Brunnermeier and Joseph Abadi have argued that no cryptocurrency can fully satisfy the three desirable properties of decentralization, correctness, and cost-efficiency. Unlike centralized institutions such as banks, blockchain technology works by generating a sort-of consensus among its participants about what constitutes a legitimate transaction. By its nature, the process tends to be very resource-intensive. Bitcoin’s Big Environmental Footprint Chart 4Bitcoin Is Not Your Eco-Currency (I) This raises another problem with Bitcoin: Its environmental impact. A single Bitcoin transaction consumes more than four times as much energy as 100,000 Visa transactions (Chart 4). Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 5). The Bitcoin algorithm requires that “miners” solve computationally intensive problems to earn new coins. It should be stressed that the solutions to these problems have no social value. Miners are not solving protein-folding algorithms that are useful for the discovery of new drugs. They are basically wasting CPU cycles by competing with one another to guess extremely large numbers in the hopes of acquiring a shrinking volume of new coins (the total number of Bitcoins that can ever be produced is limited to 21 million). Chart 5Bitcoin Is Not Your Eco-Currency (II) To make matters worse, more than two-thirds of Bitcoin mining takes place in China, where electricity is primarily generated using coal. Companies that claim to be environmentally conscious have no business trafficking in Bitcoin. What Explains The Bitcoin Bubble? Given the seemingly intractable existential problems that Bitcoin faces, why has its price gone through the roof? To some extent, the euphoria over Bitcoin is part of a broader speculative mania that has swept over everything from shares of electric vehicle companies to dubious SPACs and highly shorted “meme stocks.” No commentary about Bitcoin on the internet is complete with an obligatory prediction that it is “going to da moon.” Chart 6Lower Spending And Higher Income Led To Mounting Excess Savings Occasionally funny late-night talk show host John Oliver has joked that Bitcoin is “everything you don’t understand about money combined with everything you don’t understand about computers.” When people don’t have a good basis for determining what something is worth, they can let their imaginations run wild, causing prices to become unhinged from reality. Bitcoin and other cryptocurrencies are especially susceptible to feedback loops because they rely on network effects: The more people that use Bitcoin, the more appealing it is for others to use it. PayPal’s decision to let its customers trade Bitcoin on its platform, as well as Tesla’s announcement that it will accept it as payment, have stoked hopes that the digital currency is about to go mainstream. A surfeit of savings has also helped propel Bitcoin. US households accumulated $1.5 trillion in excess savings in 2020, two-thirds of which came from spending less than they normally would (Chart 6). The counterpart to the savings glut is a dearth of high-yielding assets. Bitcoin does not generate any cash flow, but with real rates still in negative territory, the prospect of capital appreciation has been more than enough to compensate investors for that deficiency. Bitcoin: Risks Tilted To The Downside Of course, if the price of Bitcoin were to start trending lower, speculators could flee the currency en masse. And therein lies the problem: If people decide that Bitcoin is not worth much, then it will not be worth much. Chart 7The Uses Of Gold: A Breakdown One could argue that the same risk plagues gold. There is some truth to this argument, but it should be noted that gold does have alternative uses, most notably jewelry. According to the World Gold Council, jewelry comprised 46% of the above-ground stock of gold at the end of 2020. Private investors held 22% of the gold stock, while central banks held 17% (Chart 7). Bitcoin has absolutely no alternative use to fall back on. Whereas central banks have been willing to hold gold as part of their external reserves, the same courtesy is unlikely to be extended to Bitcoin. The existence of fiat currencies gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin would deprive them of that power. Governments derive significant benefits from the ability of their central banks to create money out of thin air and use it to purchase goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. Bitcoin threatens this stream of revenue. Speaking to The New York Times DealBook conference on Monday, Treasury Secretary Janet Yellen panned Bitcoin: “To the extent it is used I fear it’s often for illicit finance” she said, adding “It’s an extremely inefficient way of conducting transactions, and the amount of energy that’s consumed in processing those transactions is staggering.” Many companies have cozied up to Bitcoin in order to associate themselves with the digital currency’s technological mystique. As ESG funds start to flee Bitcoin, its price will begin a downward spiral. Stay away.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com    

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. Appendix: GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar

Special Report

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Special Report

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The multiple paid for oil sector profits is collapsing because the market fears that the profits slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility, but an existential fear for fossil-fuelled road transportation in the post-pandemic world. Stay structurally underweight oil and gas. Within the cyclical and value segments of the equity market, overweight metals and miners versus oil and gas. Structurally underweight the stock markets of Norway and the UK which are oil and gas heavy. Structurally overweight the stock markets of Germany, Switzerland, and Denmark which have zero exposure to oil and gas or basic resources. Fractal trade: tin’s near-vertical rally is at high risk of correction. Feature Chart of the WeekOil Production Has Gone Nowhere The Brent crude oil price recently hit $65, not far below its pre-pandemic level of $69. Yet in the stock market, oil and gas equities remain the dogs, languishing 32 percent below their pre-pandemic price level. Relative to the market, the oil and gas sector has underperformed by 42 percent, and the underperformance has been almost a straight line down. Moreover, since last June when the crude oil price has risen by 50 percent, oil and gas equity prices have gone nowhere. This massive divergence of a surging crude oil price from slumping oil and gas equities raises the obvious question, what can explain this dichotomy? (Chart I-2 and Chart I-3) Chart I-2Oil And Gas Equities Have Slumped In Absolute Terms... Chart I-3...And In Relative ##br##Terms One apparent puzzle is that the oil sector’s profits have underperformed their established relationship with the crude oil price. In fact, there is no puzzle. The oil sector’s profits might appear to track the oil price, but the reality is that profits track the value of oil production, meaning the product of oil production and the oil price. Clearly though, if output is flat, then profits will appear to track the oil price.  But as it took a massive cut in oil output to support the oil price, the value of oil production and therefore, the oil sector’s profits, have significantly underperformed the oil price. Put another way, if you need to cut output to boost the commodity price it might help the commodity price, but it doesn’t much help the equity sector’s profits! (Chart I-4 and Chart I-5). Chart I-4Oil And Gas Profits Appear To Track The Oil Price Chart I-5In Reality, Oil And Gas Profits Track The Value Of Oil Output Will Fossil-Fuelled Road Transportation Be Driven To Extinction? We can now explain the 42 percent underperformance of oil equities, and perhaps more importantly, forecast what will happen next. When the pandemic took hold, and economic mobility ground to a halt, the oil sector’s 12-month forward profits slumped. Bear in mind that aviation accounts for 8 percent of oil consumption but, more crucially, road transportation accounts for half of all oil consumption. However, as the pandemic’s impact was expected to be short-lived, the multiple paid for those depressed 12-month forward profits rose. This partly compensated for the profit slump, but still left oil equity prices much lower. The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. When profits started to recover – albeit, as just discussed, by much less than the oil price rise – it should have boosted oil equity prices. The problem was that the multiple paid for those profits fell by much more than the recovery in profits, with the result that oil equities continued to underperform. Begging the question, why is the multiple paid for oil sector profits collapsing? (Chart I-6) Chart I-6Why Is The Multiple Paid For Oil Sector Profits Collapsing? The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility. The fear has become existential. Governments’ plans for pandemic stimulus and recovery have put green energy at front and centre stage. Thereby the recovery has fast-tracked the ultimate nemesis of the oil industry – the extinction of fossil-fuelled road transportation. Are the fears for oil consumption justified? Yes. Aviation is not likely to reach its pre-pandemic level of oil consumption for many years, and long-haul aviation may never get there. But the much bigger threat is fossil-fuelled road transportation. From October 2021, London will extend its Ultra Low Emission Zone (ULEZ) to an 8 mile radius from the city centre.1 The effect will be to banish from London all diesel-fuelled vehicles made before 2015 as well as some older petrol-fuelled vehicles. We expect other major cities to follow London’s example. In most cases, this initiative will happen regardless of the success (or not) of electric vehicles (EVs). Combined with other green initiatives around the world, policymakers’ unashamed aim is to drive fossil-fuelled road transportation to extinction. To repeat, road transportation accounts for half of all oil consumption. The upshot is that the structural downtrend in oil consumption will persist unless the shift away from fossil-fuelled road transportation hits a brick wall, or at least a bottleneck. We do not see such a brick wall or a bottleneck in the foreseeable future. We conclude that though the sector may offer occasional countertrend tactical buying opportunities, long-term equity investors should underweight oil and gas. Structurally Prefer Metals And Miners To Oil And Gas The preceding analysis of the oil sector can be extended to other commodity equities, like the metals and miners. To reiterate, it is the total value of commodity output – the product of commodity production and the commodity price – that drives the profits of commodity equities. On this basis, the long-term prospects for the metals and miners appear somewhat brighter than for oil and gas equities (Chart I-7). Chart I-7Commodity Sector Profits Track The Value Of Commodity Output Looking at the production of copper, it has increased by around 25 percent over the past decade, albeit this is just in line with world real GDP. By comparison, the production of oil has gone nowhere (Chart of the Week). It is the total value of commodity output that drives the profits of commodity equities. Turning to price, relative to the 2011 high the copper price is around 15 percent lower, whereas the oil price is 50 percent lower (Chart I-8). Chart I-8The Copper Price Has Outperformed The Oil Price Hence, on the all-important value of output, copper has moved in a sideways channel over the past decade while oil has been in an unmistakeable structural downtrend, with lower highs and lower lows (Chart I-9). Chart I-9The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil This relative trend is likely to continue as the shift from fossil-fuelled road transportation to EVs will weigh on oil demand, while supporting copper (and other metal) demand. We do not recommend an outright overweight in metals and miners given that their profits are just moving in a sideways channel. However, within the cyclical and value segments of the equity market, a good structural position is to overweight metals and miners versus oil and gas. When Oil And Gas Underperforms, So Does Norway’s OBX And The UK’s FTSE 100 Regional and country equity market performances is driven by the dominant sectors within each stock market. In relative terms, it is also driven by the sectors that are missing. If the oil and gas sector is a structural underperformer, then oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too. If the oil and gas sector is a structural underperformer, it inevitably means that oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too (Chart I-10 and Chart I-11). Chart I-10When Oil And Gas Underperforms, Norway's OBX Underperforms... Chart I-11...And The UK's FTSE 100 ##br##Underperforms The corollary is that stock markets which are under-exposed to the structurally underperforming sector will be at a relative advantage. This supports our structural overweighting to the stock markets of Germany, Switzerland, and Denmark, which all have zero exposure to oil and gas and basic resources. Fractal Trading System* Tin’s near-vertical rally is at high risk of correction based on fragility on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to short tin versus lead, setting a profit target and symmetrical stop-loss at 13 percent. In other trades, the underweights to China and Korea surged, but short AUD/JPY and short copper/gold reached their stop-losses. The rolling 12-month win ratio stands at 57 percent. Chart I-12Tin Vs. Lead When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1   ULEZ will be the zone inside London’s North Circular and South Circular Roads. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations