Liquidity/Growth

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

Highlights China's high-profile jawboning draws attention to tightness in metals markets, and raises the odds the State Reserve Board (SRB) will release some of its massive copper and aluminum stockpiles in the near future. Over the medium- to long-term, the lack of major new greenfield capex raises red flags for the IEA's ambitious low-carbon pathway released last week, which foresees the need for a dramatic increase in renewable energy output and a halt in future oil and gas investment to achieve net-zero emissions by 2050. Copper demand is expected to exceed mined supply by 2028, according to an analysis by S&P, which, in line with our view, also sees refined-copper consumption exceeding production this year (Chart of the Week). A constitution re-write in Chile and elections in Peru threaten to usher in higher taxes and royalties on mining in these metals producers, placing future capex at risk. Chile's state-owned Codelco, the largest copper producer in the world, fears a bill to limit mining near glaciers could put as much as 40% of its copper production at risk. We remain bullish copper and look to get long on politically induced sell-offs as the USD weakens. Feature Politicians are inserting themselves in the metals markets' supply-demand evolutions to a greater degree than in the past, which is complicating the short- and medium-term analysis of prices. This adds to an already-difficult process of assessing markets, given the opacity of metals fundamentals – particularly inventories, which are notoriously difficult to assess. Chinese Communist Party (CCP) jawboning of market participants in iron ore, steel, copper and aluminum markets over the past two weeks has weakened prices, but, with the exception of steel rebar futures in Shanghai – down ~ 17% from recent highs, and now trading at ~ 4911 RMB/MT –  the other markets remain close to records.  Benchmark 62% Fe iron ore at the port of Tianjin was trading ~ 4% lower at $211/MT, while copper and aluminum were trading ~ 5.5% and 6.5% off their recent records at $4.535/lb and $2,350/MT, respectively. In addition to copper, aluminum markets are particularly tight (Chart 2). Jawboning aside, if fundamentals continue to keep prices elevated – or if we see a new leg up – China's high-profile jawboning could presage a release by the State Reserve Board (SRB) of some of its massive copper and aluminum stockpiles in the near term. In the case of copper, market guesses on the size of this stockpile are ~ 2mm to 2.7mm MT. On the aluminum side, Bloomberg reported CCP officials were considering the release of 500k MT to quell the market's demand for the metal. Chart of the WeekContinue Tightening In Copper Expected Continue Tightening In Copper Expected Continue Tightening In Copper Expected Chart 2Aluminum Remains Tight Aluminum Remains Tight Aluminum Remains Tight Brownfield Development Not Sufficient Our balances assessments continue to indicate key base metals markets are tight and will remain so over the short term (2-3 years). Economies ex-China are entering their post-COVID-19 recovery phase. This will be followed by higher demand from renewable generation and grid build-outs that will put them in direct competition with China for scarce metals supplies for decades to come. Markets will continue to tighten. In the bellwether copper market, we expect this tightness to remain a persistent feature of the market over the medium term – 3 to 5 years out – given the dearth of new supply coming to market. Copper prices are highly correlated with the other base metals (Chart 3) – the coefficient of correlation with the other base metals making up the LME's metals index is ~ 0.86 post-GFC – and provide a useful indicator of systematic trends in these markets. Chart 3Copper Correlation With LME Index Ex-Copper Less Metal, More Jawboning Less Metal, More Jawboning Copper ore quality has been falling for years, as miners focused on brownfield development to extend the life of mines (Chart 4). In Chart 5, we show the ratio of capex (in billion USD) to ore quality increases when capex growth is expanding faster than ore quality, and decreases when capex weakens and/or ore quality degradation is increasing. Chart 4Copper Capex, Ore Quality Declines Less Metal, More Jawboning Less Metal, More Jawboning Chart 5Capex-to-Ore-Quality Decline Set Market Up For Higher Prices Less Metal, More Jawboning Less Metal, More Jawboning Falling prices over the 2012-19 interval coincide with copper ore quality remaining on a downward trend, likely the result of previous higher prices that set off the capex boom pre-GFC. The lower prices favored brownfield over greenfield development. Goehring and Rozencwajg found in their analysis of 24 mines, about 80% of gross new reserves booked between 2001-2014 were due not to new mine discoveries but to companies reclassifying what was once considered to be waste-rock into minable reserves, lowering the cut-off grade for development.1 This is consistent with the most recent datapoints in Chart 5, due to falling ore grade values, as companies inject less capex into their operations and use it to expand on brownfield projects. Higher prices will be needed to incentivize more greenfield projects. A new report from S&P Global Market Intelligence shows copper reserves in the ground are falling along with new discoveries.2 According to the S&P analysts, copper demand is expected to exceed mined supply by 2028, which, in line with our view, sees refined-copper consumption exceeding production this year. Renewables Push At Risk Just last week, the IEA produced an ambitious and narrow path for governments to collectively reach a net-zero emissions (NZE) goal by 2050.3 Among its many recommendations, the IEA singled out the overhaul of the global electric grid, which will be required to accommodate the massive renewable-generation buildout the agency forecasts will be needed to achieve its NZE goals. The IEA forecasts annual investment in transmission and distribution grids will need to increase from $260 billion to $820 billion p.a. by 2030. This is easier said than done. Consider the build-out of China's grid, which is the largest grid in the world. To become carbon neutral by 2060, per its stated goals, investment in China’s grid and associated infrastructure is expected to approach ~ $900 billion, maybe more, over the next 5 years.4 The world’s largest fossil-fuel importer is looking to pivot away from coal and plans to more than double solar and wind power capacity to 1200 GW by 2030. Weening China off coal and rebuilding its grid to achieve these goals will be a herculean lift. It comes as no surprise that IEA member states have pushed back on the agency's NZE-by-2050 plan. This primarily is because of its requirement to completely halt fossil-fuel exploration and spending on new projects. Japan and Australia have pushed back against this plan, citing energy security concerns. Officials from both countries have stated that they will continue developing fossil fuel projects, as a back-up to renewables. Japan has been falling behind on renewable electricity generation (Chart 6). Expensive renewables and the unpopularity of nuclear fuel could make it harder for the world’s fifth largest fossil fuels consumer to move away from fossil fuels. Around the same time the IEA released its report, Australia committed $464 million to build a new gas-fired power station as a backup to renewables. Chart 6Japan Will Continue Building Fossil-Fuel Back-Up Generation Japan Will Continue Building Fossil-Fuel Back-Up Generation Japan Will Continue Building Fossil-Fuel Back-Up Generation Just days after the IEA report was published, the G7 nations agreed to stop overseas coal financing. This could have devastating effects for emerging and developing nations‘ electricity grids which are highly dependent on coal. In 2020 70% and 60% of India and China’s electricity respectively were produced by coal (Chart 7).5 Chart 7EM Economies Remain Reliant On Coal-Fired Generation Less Metal, More Jawboning Less Metal, More Jawboning Near-Term Copper Supply Risks Rise Even though inventories appear to be rebuilding, mounting political risks keep us bullish copper (Chart 8). Lawmakers in Chile and Peru are in the process of re-writing their constitutions to, among other things, raise royalties and taxes on mining activities in their respective countries. This could usher in higher taxes and royalties on mining for these metals producers, placing future capex at risk. In addition, Chile's state-owned Codelco, the largest copper producer in the world, fears a bill to limit mining near glaciers could put as much as 40% of its copper production at risk.6 None of these events is certain to occur. Peruvian elections, for one thing, are too close to call at this point, and Chile has a history of pro-business government. However, these are non-trivial odds – i.e., greater than Russian roulette odds of 1:6 – and if any or all of these outcomes are realized, higher costs in copper and lithium prices would result, and miners would have to pass those costs on to buyers. Bottom Line: We remain bullish base metals, especially copper. Another leg up in copper would pull base metals higher with it. We would look to get long on politically induced sell-offs, particularly with the USD weakening, as expected Chart 8Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Commodities Round-Up Energy: Bullish Next Tuesday's OPEC 2.0 meeting appears to be a fairly staid affair, with little of the drama attending previous gatherings. Russian minister Novak observed the coalition would be jointly "calculating the balances" when it meets, taking into account the likely official return of Iran as an exporter, according to reuters.com. We expect a mid-year deal on allowing Iran to return to resume exports under the nuclear deal abrogated by the Trump administration in 2019, and reckon Iran has ~ 1.5mm b/d of production it can bring back on line, which likely would return its crude oil production to something above 3.8mm b/d by year-end. We are maintaining our forecast for Brent to average $64.45/bbl in 2H21; $75 and $78/bbl, in 2022 and 2023, respectively. By end 2023, prices trade to $80/bbl. Our forecast is premised on a wider global recovery going into 2H21, and continued production discipline from OPEC 2.0 (Chart 9). Base Metals: Bullish Our stop-losses was elected on our long Dec21 copper position on May 21, which means we closed the position with 48.2% return. The stop loss on our long 2022 vs short 2023 COMEX copper futures backwardation recommendation also was elected on May 20, leaving us with a return of 305%. We will be looking for an opportunity to re-establish these positions. Precious Metals: Bullish We expect the collapse in bitcoin prices, the US Fed’s decision to not raise interest rates, and a weakening US dollar to keep gold prices well bid (Chart 10). China’s ban on cryptocurrency services and Musk’s acknowledgment of the energy intensity of Bitcoin mining sent Bitcoin prices crashing. The Fed’s decision to keep interest rates constant, despite rising inflation and inflation expectations will reduce the opportunity cost of holding gold. According to our colleagues at USBS, the Fed will make its first interest rate hike only after the US economy has reached "maximum employment". The Job Openings and Labor Turnover Survey reported that job openings rose nearly 8% in March to 8.1 million jobs, however, overall hiring was little changed, rising by less than 4% to 6 million. As prices in the US rise and the dollar depreciates, gold will be favored as a store of value. On the back of these factors, we expect gold to hit $2,000/oz. Ags/Softs: Neutral Corn futures were trading close to 20% below recent highs earlier in the week at ~ $6.27/bu, on the back of much faster-than-expected plantings. Chart 9 Brent Prices Going Up Brent Prices Going Up Chart 10 US Dollar To Keep Gold Prices Well Bid US Dollar To Keep Gold Prices Well Bid     Footnotes 1     Please refer to Goehring & Rozencwajg’s Q1 2021 market commentary. 2     Please see Copper cupboard remains bare as discoveries dwindle — S&P study published by mining.com 20 May 2021. 3    Please see Net Zero by 2050 – A Roadmap for the Global Energy Sector, published by the IEA. 4    Please see China’s climate goal: Overhauling its electricity grid, published by Aljazeera.  5    We discuss this in detail in Surging Metals Prices And The Case For Carbon-Capture published 13 May 2021, and Renewables ESG Risks Grow With Demand, which was published 29 April 2021.  Both are available at ces.bcaresearch.com. 6    Please see A game of chicken is clouding tax debate in top copper nation, Fujimori looks to speed up projects to tap copper riches in Peru and Codelco says 40% of its copper output at risk if glacier bill passes published by mining.com 24, 23 and 20 May 2021, respectively.    Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Investors’ hunt for yield over the past few years led them to view leveraged loans as an attractive investment. Characterized by low volatility and attractive risk-adjusted returns, leveraged loans can add value to a portfolio. Leveraged loans tend to outperform their fixed-rate counterparts (for example, high-yield bonds) in an environment of rising rates and an attractive valuation starting point. Only the former criterion is true currently. Risks do exist, however. The increasing share of covenant-lite issues, and rising leverage in the corporate sector are of particular concern. Over the next 6-to-12 months, we do not expect rates to rise substantially, making the asset class somewhat unappealing in the short term. The longer-term outlook is attractive nevertheless, since rates are likely to rise as inflation picks up over the coming years. Feature In today’s environment of ultra-accommodative monetary policy, including low interest rates, and unattractive valuations for fixed-income risk assets, investors have no option but to look beyond conventional fixed-income instruments and dial up their risk appetite. In this Special Report, we run through the mechanics of the leveraged loan market. We analyze historical risk-return characteristics and compare leveraged loans to other assets. We also assess their performance during periods of financial-market stress as well as periods of rising rates and inflation. Finally, we discuss the risks associated with owning leveraged loans. What Are Leveraged Loans? Leveraged loans are a type of syndicated loan made to sub-investment-grade companies. Generally, these firms are highly indebted, with low credit ratings. A syndicated loan is structured, arranged, and administered by one or several commercial or investment banks.1 The majority of these loans are senior secured loans and are based on a floating rate, mostly LIBOR plus a premium (more than 150-200 bps) to account for their riskiness as well as to attract non-bank institutional investors. The interest rates on these loans adjust at regular intervals to reflect changes in short-term interest rates; this constitutes a benefit for investors worried about rising rates. Definitions vary when it comes to categorizing leveraged loans. Some group them based on the borrower’s riskiness and their credit rating. Others consider leverage metrics such as debt-to-capital and debt-to-EBITDA. Other classifications look at the spread at issuance or the purpose of the fund raising, which can include funding mergers and acquisitions (M&A), leveraged buyouts (LBOs), refinancing existing debt, or general funding. Over the past five years, approximately 50% of US leveraged loans issued were for refinancing purposes (Chart 1, panel 1). Within the three categories, LBO financing is deemed the riskiest, and this is reflected in its higher spread (Chart 1, panel 2). The leveraged-loan market became particularly popular in the mid-1980s as M&A activity was soaring (Chart 2). Chart 1Uses Of Leveraged Loans Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 2The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth The Boom In Corporate Activity In The 1980s Fueled Leveraged Loan Growth There are two common types of financing facilities:2 Term loans: An agreement to borrow a sum of money that is paid back over a certain payment schedule. These loans are mainly provided by non-bank entities. Revolving facilities: A type of loan that can be repeatedly drawn upon and repaid. These loans are mostly originated and held by banks. Estimates for the size of the leveraged-loan market vary depending on which criteria and definitions are used. The size of the leveraged-loan market, following rapid growth since the beginning of the past decade, is estimated to be over $1.2 trillion as of Q2 2020.3 While this represents only a small portion of overall corporate debt (it is only 15% the size of the corporate bond market), the interconnections between key market participants and the role of banks in the market has caught the attention of several regulators such as US Treasury Secretary Janet Yellen, debt investors such as Howard Marks, and international institutions such as the Bank For International Settlements (BIS). The focus of their concerns has been on the declining credit standards for leveraged loans – particularly, the increase in issuance of “covenant-lite” (cov-lite) loans, inconsistent definitions of EBITDA in loan agreements, the growth in use of “EBITDA add backs”,4 and the accuracy of leveraged-loan ratings.5 We discuss some of those concerns in the Risks section. Table 1Risky Loans Are Mainly Held By Non-Bank Entities… Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Over the past several decades, the role of banks in providing capital to the leveraged loan market has shrunk and has been replaced by non-bank lenders such as mutual funds, hedge funds, insurance companies, and asset managers.6 Data by the Shared National Credit (SNC) program7 shows that non-bank entities in the US now hold close to 83% of all non-investment-grade term loans (Table 1). Moreover, estimates by the Bank of England8 (BoE) show that a quarter of the global stock of leveraged loans (which it estimates at close to $3.4 trillion) is held through collateralized loan obligations (CLOs)9 and approximately half is owned by non-bank institutions. In turn, those non-bank institutions hold a significant portion of CLOs – particularly the riskier tranches. This is not to say that banks are not exposed to leveraged loans. But banks predominantly invest in the highest, AAA, tranche of CLOs, and investment-grade loans.10 Riskier-rated loans are held by CLOs, mutual funds, and other lenders such as hedge funds (Chart 3).11 Chart 3…Particularly Those Rated Below BB Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Historical Risk And Return Chart 4Leveraged Loans' Relative Performance Moves With Interest Rates Leveraged Loans' Relative Performance Moves With Interest Rates Leveraged Loans' Relative Performance Moves With Interest Rates Since 1997, leveraged loans12 have returned an annualized 4.9%, 25 basis points higher than US Treasurys and approximately 100 and 200 basis points less than US investment-grade and high-yield bonds, respectively. They have underperformed US equities by an annualized 400 basis points over the same period. Declining rates over the past two decades are the most likely reason leveraged loans have underperformed their fixed-rate counterparts. The relative performance of leveraged loans to investment-grade bonds has closely tracked the trajectory of Treasury yields (Chart 4). While the case is not as clear for relative performance against high-yield bonds, the trend is similar. However, on a risk-adjusted return basis, due to reduced volatility, leveraged loans did outperform both equities and high-yield corporate bonds (Table 2). We nevertheless think that volatility is likely understated given the elevated kurtosis. The larger negative skew and excess kurtosis could indicate higher probabilities of large negative returns (Chart 5).   Table 2Historical Risk-Return Characteristics Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 5Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Leveraged Loans' Returns Exhibit High Kurtosis And Negative Skewness Why Should Investors Consider Leveraged Loans? Chart 6Rising Rates Support Higher Return From Leveraged Loans... Rising Rates Support Higher Return From Leveraged Loans... Rising Rates Support Higher Return From Leveraged Loans... Our US bond strategists have showed that the odds of leveraged loans outperforming fixed-rate high-yield bonds increase when certain criteria are in place – particularly when valuations are tilted in loans’ favor, and Treasury yields are rising.13 Only the latter criterion is true currently. Year-to-date, leveraged loans have returned 2.2%, higher than the -3.2%, -3.4%, 1.6%, and -3.4% from US Treasurys, investment-grade bonds, high-yield bonds, and emerging markets sovereign debt, respectively (Chart 6). During the same period, Treasury yields rose by 65 basis points. We find that periods of rising Treasury yields are associated with increased flows into the asset class (Chart 7). More interestingly, leveraged loans outperform junk bonds when Treasury yields rise faster than what is discounted in the forwards curve over the following 12 months (Chart 8). Chart 7...As Well As Increased Fund Flows ...As Well As Increased Fund Flows ...As Well As Increased Fund Flows Chart 8Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve Leveraged Loans Will Benefit If Interest Rates Rise By More Than What Is Discounted In The Forward Curve     This does not seem to be the case today, however, with the 5-year, 1-year forward about 40 basis points higher than the current 5-year Treasury yield. This is in line with our view that rates are unlikely to rise substantially over the next 6-to-12 months. Inflation, beyond a temporary spike over the next few months, should remain subdued, at least until employment is back to a level which would put upward pressure on wages. This is unlikely before 2023. It is also important to consider the potential trajectory of monetary policy as well as changes in long-term yields. The Fed, through its dot plot, is signaling no increase in the Fed Funds Rate before 2024, but the market is becoming worried about inflationary pressures and pricing in an earlier Fed hike. We believe it unlikely that the Fed will raise rates ahead of what the market expects, unless the labor market returns to “maximum employment” over the next 12 months. The yield on leveraged loans has been lower than on high-yield bonds for most of the period we have data for, except early 2020. Given leveraged loans’ senior position in a firm’s capital structure, it makes sense that their yields are lower. Additionally, the sector composition of the two markets plays a role: Leveraged loans are more exposed to the Technology and Communications sectors and have a limited allocation (averaging 1% over the past seven years) to the Energy sector, unlike high-yield, fixed-rate bonds (where the weight of Energy has averaged 13%) (Chart 9). This was mostly evident when the yield differential collapsed to below -3% during the 2014/2015 oil crash (Chart 10). Chart 9Leveraged Loans’ Sector Weightings Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 10Loan Spreads Are Not Looking Attractive Loan Spreads Are Not Looking Attractive Loan Spreads Are Not Looking Attractive Chart 11Recent Investor Demand Pushed Up Leveraged Loan Prices Recent Investor Demand Pushed Up Leveraged Loan Prices Recent Investor Demand Pushed Up Leveraged Loan Prices The yield differential has, however, been trending upwards since then, and at current prices, upside may be limited. The recent surge in investor demand has pushed down yields on newly issued leveraged loans, moving the average bid price of leveraged loans above its pre-pandemic high (Chart 11). In the next section, we analyze how leveraged loans have behaved during recessions and other periods of financial market stress.   Financial Market Stress Performance In Crises Given the index’s short history, we are able to cover only the past three recessions (the dot-com bubble bust, the Global Financial Crisis (GFC), and the COVID-19 recession). We also look at the 2013 Taper Tantrum and the 2014/2015 oil price shock. In all cases, leveraged loans fell and subsequently recovered along with other fixed-income asset classes. The Taper Tantrum was the most favorable for leveraged loans: 10-year Treasury yields rose by 100 basis points over four months (Chart 12). Table 3 shows that periods of rising rates are a better environment for leveraged loans than those of declining rates. We also looked at a period of Fed tightening and easing cycles – although the timing of easing cycles overlaps with, recessions, dragging down the performance of leveraged loans. We also assess the impact of inflation on leveraged loans using the framework from our Special Report on inflation hedging,14 which decomposed inflation into four quartiles/regimes: Inflation levels below 2.3%, between 2.3% and 3.3%, between 3.3% and 4.9%, and above 4.9%. We add periods of decreasing inflation to our analysis. We note, however, that there was only one period where inflation was over the 4.9% threshold. Chart 12Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress Leveraged Loans Fared Well In Periods Of Credit- And Sector-Specific Distress   Table 3Leveraged Loans’ Performance During Different Rate Cycles… Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Table 4…And Inflation Regimes Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? During periods in the first and second inflation quartiles, leveraged loans, in absolute terms, had the highest average annualized returns, 8.1% and 10% respectively. This makes sense since in those regimes, policy rates are low and bond yields begin to rise given robust growth. Leveraged loans, however, underperformed fixed-rate bonds during those periods. Inflation above 3.3% represents an environment in which the economy begins to overheat and growth to falter. This regime saw leveraged loans outperform high-yield bonds by an annualized 1.5%. Periods of declining inflation also showed moderately positive annualized returns for leveraged loans (Table 4).   Risks Chart 13Corporate Health Has Worsened... Corporate Health Has Worsened... Corporate Health Has Worsened... The growth of the leveraged loans market reflects multiple trends but, most importantly, a broad increase in corporate leverage, driven by a decline in interest rates and increasing availability of cheap financing. The debt-to-asset ratio of nonfinancial businesses, a gauge of corporate leverage, is at a 20-year high (Chart 13, panel 1). This raises concerns about the overall health of the corporate sector – particularly firms’ ability to service their debt – since the median interest coverage ratio is near a level last seen during the GFC. This measure is even negative for companies within the 25th percentile, meaning companies in that bucket lack funds to maintain their interest payments (Chart 13, panel 2). Trends in the leveraged loan market paint a similar picture. The share of newly issued loans by the most highly levered firms – those with a debt-to-EBITDA ratio of 6x or higher – has reached new highs, hitting 37% of new loans in Q3 2020 (Chart 14). Chart 14…Even For Leveraged Lending Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? Chart 15Cov-Lite Issuances Make Up Almost 80% Of New Issuances Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? The providers of capital are partly to blame. Even with credit standards deteriorating, firms looking for capital were mostly able to find it. The share of cov-lite structures – loans that lack the protective covenants found in traditional loans – continues to grow and now comprises almost 80% of new issuance (Chart 15). Cov-lite loans typically do not have any maintenance covenants, requirements to maintain certain ratios such as leverage or interest-coverage ratios.15 Instead, they feature incurrence covenants which have to be met only if the issuer wants to take particular actions, such as taking on more debt.16 This loosening of credit terms is mostly a function of increased demand, particularly by CLO buyers and other non-bank institutional investors, in an environment of low yields. Some have even warned that vulnerabilities in the leveraged-loan market could cause disturbance to the overall financial system. Particularly, memories of the GFC and worries about the “originate-to-distribute” model – whereby banks originate loans but retain only a fraction on their balance sheets – have led some observers to suggest this could all lead to a risky expansion of credit, and trigger a new financial crisis. Chart 16Leveraged Loans Have Higher Average Credit Ratings… Is It The Right Time For Leveraged Loans? Is It The Right Time For Leveraged Loans? We do not share this skepticism. Banks’ exposure to leveraged loans is mainly via the highest tranches of CLOs. Banks’ liquidity requirements have increased since the GFC, and therefore contagion should be minimal in the event of problems in the loan market. A recent report by the US Government Accountability Office (GAO) did not find evidence that leveraged lending presented a significant threat to financial stability.17 Additionally, almost all leveraged loans are first lien, they have a senior secured position in the capital structure, higher average credit ratings than high-yield bonds (Chart 16), and lower default rates (Chart 17). Moreover, their five-year average recovery rate of 63% tops the 40% of senior unsecured bonds (Chart 18). Chart 17...Lower Default Rates... ...Lower Default Rates,... ...Lower Default Rates,... Chart 18...And Higher Recovery Rates Than High-Yield Bonds ...And Higher Recovery Rates Than High-Yield Bonds ...And Higher Recovery Rates Than High-Yield Bonds   Conclusion In a period of ultra-low interest rates and stretched valuations for risk assets, leveraged loans have emerged as an interesting asset class for investors. Due to lower volatility, leveraged loans have historically produced higher risk-adjusted returns than fixed-rate high-yield bonds. However, volatility is likely understated given elevated levels of kurtosis. Historically, rising Treasury yields and an attractive valuation starting-point provided a signal for leveraged loans’ outperformance. Only one of those two criteria are currently in place. In the next 6-to-12 months, we do not believe rates will rise substantially, making this asset class somewhat unattractive in the short term. The longer-run outlook for leveraged loans, however, is attractive. As inflation, and therefore rates, rise over the next two-to-three years, a moderate allocation to leveraged loans might be a useful hedge for investors.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1 Please see “LCD Loan Primer – Syndicated Loans: The Market and the Mechanics,” S&P Global Market Intelligence. 2 Please see “Leverage Lending FAQ & Fact Sheet,” SIFMA, February 2019. 3 Please see “Federal Reserve Financial Stability Report,” November 2020. 4 “EBITDA add backs” add back expenses and cost savings to earnings and could inflate the projected capacity of the borrowers to repay their loans. 5 Please see Todd Vermilyea, “Perspectives On Leveraged Lending,” The Loan Syndications and Trading Association 23rd Annual Conference, New York, October 24, 2018. 6 Please see “Global Financial Stability Report: Vulnerabilities in a Maturing Credit Cycle, Chapter 1,” IMF, April 2019. 7 The SNC Program is an interagency program designed to review and assess risk in the largest and most complex credits shared by multiple financial institutions. The SNC Program is governed by an interagency agreement among the three federal bank regulatory agencies - the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office Of the Comptroller Of The Currency (OCC). 8 Please see “Financial Stability Report,” Bank of England, August 2020. 9 CLOs are asset-backed securities issued by a special purpose vehicle which acquire a portfolio of leveraged loans. 10 Please see “Turns Out Leveraged Loans Aren’t a Systemic Risk After All,” Bank Policy Institute, February 8, 2020. 11 Please see Seung Jung Lee, Dan Li, Ralf R. Meisenzahl, and Martin J. Sicilian, “The U.S. Syndicated Term Loan Market: Who holds what and when?”, November 25, 2019. 12 For the purpose of this report, we use the S&P/LSTA Leveraged Loan Index, which tracks the market-weighted performance of US dollar-denominated institutional leveraged loan portfolios. 13 Please see US Bond Strategy Report, “The Price Of Safety,” dated January 27, 2015. 14 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 15 Please see Eric Goodison And Margot Wagner, Paul, Weiss, Rifkind, Wharton & Garrison Llp, “Covenant-Lite Loans: Overview,” August 2019. 16 Please see Scott Essexx, Alexander Ott, Partners Group, “The Current State Of The Leveraged Loan Market: Are There Echoes Of The 2008 Subprime Market?”, March 2019. 17 Please see “Financial Stability: Agencies Have Not Found Leveraged Lending To Significantly Threaten Stability But Remain Cautious Amid Pandemic,” United States Government Accountability Office, December 2020.

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 2US Natgas Inventories Return To Five-Year Average US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 4US LNG Exports Set Records In November And December 2020 US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely US-Russia Conflit Likely US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Copper Prices Surge As Global Storage Draws Copper Prices Surge As Global Storage Draws Chart 10 Gold Disconnected From US Dollar And Rates Gold Disconnected From US Dollar And Rates       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Portfolio Strategy Execute a long S&P energy/short global gold miners pair trade to take advantage of the liquidity-to-growth handoff. Initiate another new trade, long S&P materials/short S&P utilities, to benefit from a shifting macro landscape. Synchronized global growth and commodity inflation are a boon for materials, but a bane for utilities. Recent Changes Initiate a long S&P energy/short global gold miners pair trade today. Initiate a long S&P materials/short utilities pair trade today. Table 1 Fraying Around The Edges? Fraying Around The Edges? Feature The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. Nevertheless, a less hawkish Fed should, at the margin, underpin equities with easy monetary and financial conditions complementing the goldilocks equity backdrop (Chart 1). In fact, the St. Louis Fed Financial Stress Index (comprising "18 weekly data series: seven interest rate series, six yield spreads and five other indicators"1) is probing multi-decade lows. This primarily bond market-dependent indicator, has historically done an excellent job in leading the S&P 500 at major turning points at both peaks and troughs (Chart 2A). Recently, it has been more of a coincident indicator with equities, and currently waves the all-clear sign (St. Louis Fed Financial Stress Index shown inverted, Chart 2B). Chart 1Timid Fed Is Supportive Timid Fed Is Supportive Timid Fed Is Supportive Chart 2AExcellent Leading Properties Excellent Leading Properties Excellent Leading Properties Chart 2BAll Clear All Clear All Clear Nevertheless, we do not want to sound too complacent and following up from last week's brief discussion of rising geopolitical uncertainty and equity market performance, we are examining key post-WWII geopolitical events in more detail. The first three columns of Table 2, courtesy of BCA's Geopolitical Strategy Service2, update these episodes to mid-2017. While the S&P 500's drawdown from the three-month peak prior to the event to the three-month trough following the event averages out to roughly 10%, drilling beneath the surface is instructive. Table 2Geopolitical Crises And SPX Returns Fraying Around The Edges? Fraying Around The Edges? On average, broad equity market returns are muted one and three months post the event. Interestingly, on a six- and twelve-month horizon following the geopolitical incident, the S&P clearly shoots higher rising on average 5% and 8%, respectively (Table 2). Chart 3 shows the average profile of the S&P 500's returns during all of these post-WWII events, three months prior to the incident up to one year forward. Chart 3Geopolitical Opportunity? Geopolitical Opportunity? Geopolitical Opportunity? Two key takeaways stand out from this analysis. First, the coming quarter will likely prove volatile as the dust has yet to settle from the recent North Korea escalation. As a result, tactically buying some portfolio protection when the market is near all-time highs, as we cautioned last week3, is prudent and in order, especially given the seasonally challenging months of September and October. Second, on a cyclical horizon, the S&P 500 will likely resume its advance, ceteris paribus. Thus, if history at least rhymes and barring another major flare up of geopolitical risk, the path of least resistance will be higher for the overall equity market into mid-2018. This week we are executing two market neutral pair trades, one levered to the liquidity-to-growth handoff and the other to the synchronized global growth theme. Liquidity-To-Growth Handoff: Buy Energy/Sell Gold Producers A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners (Chart 4). This high-octane trade would benefit most from the handoff of global liquidity to economic growth. Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago4 - pans out in the coming months, then relative share prices should reverse. Gold prices serve as a global fear proxy, while energy prices move with the ebb and flow of global growth. Importantly, the oil/gold ratio (OGR) hit all-time lows in early 2016 and subsequently enjoyed a V-shaped recovery. But, year-to-date the OGR has relapsed on the back of rising policy uncertainty (policy uncertainty shown inverted, Chart 5). If this geopolitical uncertainty recedes, the upshot is that the OGR will rise in response. Chart 4Ready For A Bounce Ready For A Bounce Ready For A Bounce Chart 5Prefer Black Gold To Bullion Prefer Black Gold To Bullion Prefer Black Gold To Bullion Importantly, global trade is reaccelerating, also suggesting that the OGR should resume its advance (Chart 5). Chart 6 shows a simple growth/liquidity gauge using BCA's Global Synchronicity Indicator. Historically, this metric has been closely correlated with relative share price momentum, and the current message is to expect a sharp turn in oversold relative share prices. Moreover, were the liquidity thrust to convert into significantly higher output, then real interest rates should begin to reflect better growth prospects, and further boost the allure of the pair trade. As with bullion, the relative share price ratio is also overly sensitive to changes in real rates. In fact the 10-year TIPS yield does an excellent job in explaining relative share price fluctuation. Even a modest upturn in real interest rates will go a long way for relative share prices (Chart 7). Chart 6Ample Catch Up Space Ample Catch Up Space Ample Catch Up Space Chart 7Liquidity-To-Growth Beneficiary Liquidity-To-Growth Beneficiary Liquidity-To-Growth Beneficiary Meanwhile, on the relative operating front, the tide is also turning, favoring energy stocks versus gold miners. The oil and gas rig count has recovered smartly from the depths of the global manufacturing recession of late 2015/early-2016. On the flip side, demand for safe haven assets should ebb and further weigh on global gold ETF flows. Additional capital inflows into gold ETF funds from current levels would require either a sizable flare up in global geopolitical risk or another downdraft in global growth. Taken together, this relative demand indicator has surged, signaling that a catch up phase looms for the relative share price ratio (bottom panel, Chart 8). Similarly, relative pricing power is on the verge of climbing into expansionary territory. Extremely depressed pricing power for oil & gas field machinery is unlikely to deflate further, as recent anecdotes of new capital expenditure projects provide some glimmers of light for utilization rates. Conversely, bullion prices are pushing $1,300/oz. near the upper bound of the four year trading range, warning that at least a digestion phase lies ahead. The middle panel of Chart 8 shows that relative pricing power has been an excellent leading indicator of relative earnings. Our relative EPS models do an excellent job in capturing all of these different macro forces, and at the current juncture emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (Chart 9). Finally, relative valuations and technicals are both flashing a green light. Relative value is as compelling as it was during the depths of the Great Recession (middle panel, Chart 10), while our Technical Indicator is one standard deviation below the historical mean. Every time such extreme oversold levels are hit, relative performance has catapulted higher in the subsequent 3-6 months. Chart 8Relative Demand And Price Outlooks##br##Favor Energy Stocks Over Gold Miners Relative Demand And Price Outlooks Favor Energy Stocks Over Gold Miners Relative Demand And Price Outlooks Favor Energy Stocks Over Gold Miners Chart 9Earnings-Led##br## Outperformance Looms Earnings-Led Outperformance Looms Earnings-Led Outperformance Looms Chart 10Unloved ##br##And Oversold Unloved And Oversold Unloved And Oversold Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. For investors seeking an alternative way to express this trade opportunity levered to the liquidity-to-growth theme, going long the S&P 1500 metals and mining index instead of the S&P energy sector would also produce similar results (bottom panel, Chart 9). New Pair Trade: Materials Vs. Utilities Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals5 and also from domestic to global-exposed market areas. In fact, our relative Cyclical Macro Indicators capture the shifting macro backdrop favoring a more cyclical portfolio tilt (Chart 11). The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (Chart 12). Chart 11Reflation Trade Reflation Trade Reflation Trade Chart 12U.S. And... U.S. And... U.S. And... Reviving global growth is typically synonymous with rising inflation expectations and bond yields. BCA's view remains that a selloff in the bond markets is the most likely scenario in the coming months. The third panel of Chart 11 shows that relative share price momentum and the bond market are joined at the hip. This makes sense as materials stocks are reflationary beneficiaries, whereas the utilities sector acts as a fixed-income proxy. Not only does the pair trade benefit from rising bond yields in isolation, but also when the stock-to-bond (S/B) ratio is on fire. Currently, a wide gap has opened between the S/B and the materials/utilities ratios that will likely narrow via a catch up phase in the latter. Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. Chart 13 highlights four different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. Materials manufacturers have a sizable export component driving both the top and bottom line. In contrast, utilities are a domestic-only play. As a result, revving global trade and the significant fall in the trade-weighted U.S. dollar will buttress relative EPS prospects (Chart 14). In fact, irrespective of where the greenback ends the year, materials profits will get a lagged bump from a positive FX translation in the back half of the year. Chart 13...Global Growth Favor ##br##Materials Over Utilities ...Global Growth Favor Materials Over Utilities ...Global Growth Favor Materials Over Utilities Chart 14Cheapened Greenback = ##br##Buy Materials At The Expense Of Utilities Cheapened Greenback = Buy Materials At The Expense Of Utilities Cheapened Greenback = Buy Materials At The Expense Of Utilities The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel, Chart 14). Relative valuations and technical conditions also wave the green flag. Our valuation indicator has corrected back to the neutral zone and the technical indicator has unwound overbought conditions, offering a compelling entry point to the pair trade (Chart 15). Finally, our newly introduced relative EPS models encapsulate all of these diverging forces. Currently, the relative profit models signal that materials earnings are on track to outpace utilities profit generation for the remainder of the year (Chart 16). Chart 15Compelling Entry Point Compelling Entry Point Compelling Entry Point Chart 16Heed The Relative Profit Model Message Heed The Relative Profit Model Message Heed The Relative Profit Model Message Consequently, there is an opportunity to execute a long materials/short utilities pair trade in order to benefit from synchronized global growth and looming bond market selloff, and softening U.S. dollar and related commodity inflation. Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade today. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key 2 Please see the August 16, 2017 Geopolitical Strategy Weekly Report titled "Can Pyongyang Derail The Bull Market?", available at gps.bcaresearch.com. 3 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks", available at uses.bcaresearch.com. 4 Please see July 31, 2017 U.S. Equity Strategy Weekly Report titled "Growth Trumps Liquidity", available at uses.bcaresearch.com. 5 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks" for a recap of our major portfolio moves since May 1, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.

The 35-year bond bull market is coming to an end and the downward sloping trend channel for yields is changing to flat. Asset allocators should trim duration and fixed income exposure.