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In the previous Tinkering With Inflation Special Report, we outlined our structural view for US inflation, namely that over the next 10 years inflation will surprise to the upside largely driven by politicians re-discovering the magic of fiscal spending. In today’s Special Report, we look at structural GICS1 sector-level implications for portfolio allocation courtesy of the looming inflationary flux, but with a major caveat. Over the years we have published numerous reports answering the question of “what to buy and what to sell” when inflation comes and goes. But, the key criticism is that our previous inflationary analysis included data from the current disinflationary era. In other words, the data was capturing the effects of reflation (i.e. inflationary spikes within the broader deflationary megatrend), rather than effects of the pure-play inflation (i.e. inflationary spikes within the broader inflationary trend). Up until recently, such analysis was well-fit for the macro environment investors were in, but given our structurally inflationary view, it pays to take a closer look at the relative GICS1 sector performance during “true” inflationary periods. The shaded areas in Chart 1 display five pure-play inflationary periods that we analyse in this Special Report. Importantly, we also treat the very first iteration with a big grain of salt as it was catalyzed by a one-off event: excessive Department of Defense (DoD) Vietnam War and Star War spending, which in turn skewed relative sector performance results (similarly to how relative sector performance during the recent pandemic-induced recession is not indicative of the typical recessionary sector performance). The Line In The Sand Before we proceed with our sectorial analysis, we must first distinguish between moves in core CPI that constitute deflation and inflation. We rely on empirical data and examine in detail the relationship between core CPI inflation, interest rates, and equites. Starting with equites, we find that the S&P 500 P/E multiple typically peaks when core CPI inflation reaches 2.3% and begins to decline once inflation climbs above 2.5% (Chart 2). At this level the market no longer finds the prospect of investing in long duration assets attractive. The investment horizon shortens as well as the multiple market participants are willing to pay for future earnings. The only adjustment we make to the 2.5% number is instead of looking at a specific inflection level, we turn it into a range of 2.3-2.7%. Chart 1True Inflationary Episodes True Inflationary Episodes True Inflationary Episodes Chart 2Inflation And The P/E Multiple Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Next, we bring fixed income into the picture and look at the correlation between SPX returns and changes in the 10-year US Treasury yield. The changes in this correlation help to distinguish between deflationary and inflationary environments due to different causality routes that exist from bonds to stocks, versus from stocks to bonds. A concrete example will help to clarify the point. When bond yields rise, they push stock prices down resulting into a negative causal correlation from yields to stocks. On the other hand, if stocks fall, then the central bank has to cut rates to protect the stock market, and in doing so it lowers yields. The end result is a positive causal correlation from stocks to yields. Negative correlation: yields rise ➜ DCF discount factor rises ➜ stocks fall Positive correlation: stocks fall ➜ central bank cuts rates ➜ yields fall Every central bank has to make the choice in which one of these two structural casual loops they operate as they can only protect one asset: either the bond market from inflation or the stock market from deflation. The choice of that key asset reveals the inflationary vs. deflationary regime. The bottom panel of Chart 3 illustrates this interplay. The top panel of Chart 3 also plots our 2.3%-2.7% inflation/deflation core CPI inflection range. Every time core CPI approached this critical range, the correlation between SPX returns and changes in the 10-year yield snapped to zero in preparation for a structural paradigm shift. This empirical exercise further illustrates that the 2.3-2.7% band in core CPI is the border between inflation and deflation. Chart 3The Border Line The Border Line The Border Line What follows is a select GICS1 sector return/positioning analysis during bouts of actual inflation. We also mainly focus on cyclical sectors since positioning within defensive GICS1 sectors is not driven by inflation, but instead it is dictated by global growth dynamics, which are beyond the scope of this Special Report.   Arseniy Urazov Senior Analyst ArseniyU@bcaresearch.com   Positioning For True Inflation: S&P Consumer Discretionary It is no secret that consumers don’t like CPI inflation as it erodes purchasing power via a multitude of channels. High interest rates that go toe to toe with inflation make big item purchases more challenging due to the higher cost of credit, hence weighing on end-demand for consumer discretionary stocks. Also, there is only so much cost pressures companies can pass onto the US consumer. The implication is that there comes a time when the entire S&P consumer discretionary sector is forced to sacrifice margins and profits. Chart 4 shows our consumer drag indicator that encapsulates both of these factors. Our thesis is that should true inflation return, the underperformance period is likely to be more severe compared with previous historical episodes (Chart 6). The reason for such a grim forecast has to do with the present-day sector composition. Following the inclusion of TSLA in this GICS1 sector, the combined exposure to AMZN and TSLA is 53% (Chart 5). Chart 4Inflationary Headwinds Inflationary Headwinds Inflationary Headwinds Chart 5Overconcentration Overconcentration Overconcentration Chart 6Inflation & Consumer Discretionary Equities Inflation & Consumer Discretionary Equities Inflation & Consumer Discretionary Equities Both of these companies are effectively a long duration trade, which disproportionately benefited from low rates via the multiple expansion channel. Should inflation return to the system and end the era of low rates, both TSLA and AMZN will fall out of investor’s favor and heavily weigh on the overall S&P consumer discretionary sector. Finally, the bottom panel of Chart 6 shows the impressive run consumer discretionary stocks had since the beginning of the millennium rising by over 100% in relative terms. The rise is also in sharp contrast to the performance from 1975 to 2000 when the sector was range bound. The implication is that should an inflation-induced normalization period take root, the risk/reward in the S&P consumer discretionary sector will lie to the downside. Bottom Line: The S&P consumer discretionary sector will underperform in an inflationary world. Positioning For True Inflation: S&P Financials Similar to their early cycle brethren consumer discretionary stocks, investors should shy away from financials when the inflation genie is out of the bottle. Outside of the anomaly Vietnam War/Moon Landing period, Chart 7 reveals that inflation is a major headwind for financials. Chart 7Inflation & Financials Equities Inflation & Financials Equities Inflation & Financials Equities There are several avenues through which it hurts the sector. The first one is the yield curve. When the Fed raises short term rates to combat inflation, it flattens the curve. The end result is that the yield curve is flatter during an inflationary era, meaning that the spread between borrowing and lending narrows for the banking sector and results in a net interest margins squeeze. As a result, profitability drops, and stock prices fall (Chart 7, bottom panel). Inflation also hurts S&P financials due to the mismatch between banks' assets and liabilities. A typical bank has longer maturity for its receipts stream than for its liabilities. Consequently, as inflation rises, it reduces the future net inflow because creditors demand higher interest rates, while the returns earned by the bank on its current loan book is mostly fixed by existing contracts. The net result is lower bank equity and subsequently lower stock prices. The example below adds more color to the argument. Table 1 shows a stylized example of a balance sheet for a commercial bank over the course of three years with the following assumptions: Table 1The Effect Of Inflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation Inflation from Year 1 to Year 2 is 5%, but it increases from Year 2 to Year 3 to 10% The bank's contracts with creditors mature in 1 year, while loans mature in 2 years Reserve requirements against all deposits are 10% Nominal interest rates on loans stand at 5% Interest rates on deposits stand at 4.5% Cash account is ignored as it doesn’t affect qualitative results The bank starts in Year 1 and extends $1,000 worth of loans maturing in two years with a 5% rate and receives $1,000 worth of deposits that grow at 4.5% per year and mature next year. The bank also has 10% ($100) of its liabilities in reserves. The difference between assets and liabilities is the bank’s equity or market value, which is also $100. Next year, the bank receives $50 (5% of $1000) in income from the loans it extended in Year 1, but a portion of this income has to be moved to reserves as the value of deposits increased by $45 (4.5% of $1000). Thus, the final value of loans is $1050 minus ($45 times the 10% reserve requirement), which equals $1045.5. The bank’s nominal equity value also increased to $105, but when adjusted for inflation it remains the same as in Year 1. Now, expected inflation for Year 3 changes from 5% to 10%, and since deposits have matured, creditors renegotiate them at a new rate of 10%, while the loans that were issued in Year 1 remain contractually bind to the original 5%. Crunching the numbers for Year 3 using new interest rates reveals that both the nominal and real value of a bank’s equity decreased due to the maturity mismatch between its assets and liabilities. Of course, the bank could have extended new loans in Year 2 at the higher 10% rate, but it would have only reduced the drop in equity value, but not eliminated it, so for the sake of simplicity we ignored that option. What this exercise showed is the second avenue through which inflation weighs on banks, and by extension, financials equities. Bottom Line: It pays to shy away from the S&P financials sector during bouts of inflation. Positioning For True Inflation: S&P Energy The S&P energy index is a classic inflation beneficiary as true inflationary impulses are synonymous with oil price surges. Chart 8 highlights how this commodity-driven sector was quick to react to all six inflationary spurts, besting the market during each of them. Chart 8Inflation & Energy Equities Inflation & Energy Equities Inflation & Energy Equities Moreover, deglobalization is likely to provide a boost to relative energy prices over a multi-year time horizon as the number of proxy wars in South America and the Middle East will likely increase, undercutting global oil supply. Hence, the geopolitical risk premia in crude oil will also rise boosting the allure of energy stocks. Finally, for investors who are choosing between energy and materials equites to express their near-term inflationary view, we would recommend sticking to the S&P Energy index in light of our unfolding China slowing down view. Chart 9 also depicts how China's dominance in the materials market is nearly absolute compared to the one in energy space. Hence, materials equities are more sensitive to the China weakness story, and investors should at the margin prefer energy equities over materials. Stay tuned for an upcoming report that will explore this idea in greater depth and recommend a new intra-commodity complex pair trade. Bottom Line: The S&P energy sector will outperform the market should deflation recede. Chart 9China And Commodities China And Commodities China And Commodities   Positioning For True Inflation: S&P Industrials The S&P industrials sector is located in the middle of the economic value chain and thus it has diminishing power to pass on inflationary cost increases especially energy related ones. At the same time, capital goods producers have other corporations as their end-demand user, which means that they suffer less from inflation than sectors at the far end of the value chain like consumer discretionary. Chart 10 shows how relative performance of the S&P industrials sector is “neither here nor there” when examining inflationary spikes. Chart 10Inflation & Industrials Equities Inflation & Industrials Equities Inflation & Industrials Equities However, taking a closer look, we do note a shorter-term pattern that unfolds within every inflationary period. The S&P industrials index outperforms in the early stages of an inflationary spike, but then gives up its gains as inflation re-accelerates. There is an intuitive explanation for this dynamic. As deflation recedes giving way to inflation, industrial stocks are able to pass on the initial price increases to their customers thus preserving margins and profits. But as inflation persists, the fact that industrials companies are located in the middle of the economic value chain becomes a headwind as they are no longer able to pass on costs increases, which in turn gets reflected in falling relative stock prices. Bottom Line: Keep the S&P industrials index in the overweight basket early on into an inflationary spike, but do not overstay your welcome as inflation endures. Positioning For True Inflation: S&P Materials Typically, inflationary pressures first manifest themselves in higher raw material costs as rising demand from increased economic growth outpaces supply, benefiting materials equities. At the same time, the fact that materials stocks are the first link in the economic value chain allows them to efficiently pass on price increases, whereas other sectors at the end of the value chain like S&P consumer discretionary typically have the hardest time doing so (Chart 11). Chart 11Inflation & Materials Equities Inflation & Materials Equities Inflation & Materials Equities The current deflationary environment has proven rocky for the S&P materials sector as it sits at the second lowest level in history following the dotcom-formed “Mariana Trench”. Should our forecast for an inflationary revival prove accurate, materials producers will be prime beneficiaries with ample upside potential. The mean relative share price ratio during the previous inflationary cycle (1960-1996) is 0.25. Today, materials are sitting at the 0.12 mark, which makes a 100%+ rise a reasonable structural forecast. Bottom Line: Materials are a secular buy in an inflationary world. Positioning For True Inflation: S&P Technology On the surface, the S&P technology sector appears to be a textbook candidate to short during inflation, but empirical data disagrees with the theory. The top panel of Chart 12 shows that there have only been two clean periods when tech underperformed during true inflationary periods (1974-1976 and 1987-1990). On the other hand, in 1977 – the year that had a very significant inflationary spike – technology stocks managed to outpace the broad market by a wide margin. Chart 12Inflation & Technology Equities Inflation & Technology Equities Inflation & Technology Equities The reason for such inconsistent performance is due to the fact that the sector is sensitive to two opposing forces: multiple contraction and real economic growth. It is well-know that currently technology stocks represent the longest duration sector within the S&P 500, but they also enjoy inelastic demand profile. In other words, corporations cannot put their guard down and fully trim CAPEX and R&D expenses even during recessions because if they do, their competition will steam roll ahead. The same holds for the consumer sector. While some tech gadgets are luxury goods, consumers cannot simply postpone their PC, phone, and software related expenses as those are necessity goods. In short, the S&P technology index is not a pure-play cyclical sector as inelastic demand profile for its goods from other economic agents gives the sector some inflation-proof properties. Given that the upcoming inflationary impulse will be fiscal-driven, we would not rush to put tech stocks in the underweight basket. Instead, we opt to stick with a neutral allocation to underscore this tug of war effect between the two forces. Bottom Line: Relative technology performance in an inflationary world will depend on whether real economic growth can compensate for multiple contraction. Stick with a benchmark allocation. So What? In this Special Report we examined how investors should be positioned for true inflation rather than reflation. Some of the key differences are the following: financials switch from being a buy during reflation to a sell during true inflation, industrials are flat when looking at the entire inflationary spike, but they outperform in the early innings and underperform in the later stages of inflation, and finally technology is not a clear underperformer as this sector is caught between two opposing forces. Now circling back to our structural inflationary view, while it will take time for the current deflationary megatrend to make a full U-turn, the incoming post-recessionary spike driven by fiscal spending and heating up of the US economy will make for the right environment to test whether last century’s inflationary correlations will still hold. Our portfolio is appropriately positioned to test this hypothesis with an overweight toward inflationary winners and a neutral weight in inflationary losers (Table 2). As a reminder we have the S&P financials sector on downgrade alert. Table 2Current Portfolio Positioning Tinkering With Inflation (Part II): True Inflation Vs. Reflation Tinkering With Inflation (Part II): True Inflation Vs. Reflation For completion purposes, Chart A1 in the Appendix on the next page also provides historical performance for defensive GICS1 sectors during true inflationary periods. Bottom Line: Investors should overweight true inflationary winners as the incoming CPI flux will unlock excellent value in those sectors.   Appendix Chart A1Appendix Appendix Appendix         Footnotes  

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

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

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices Surging Steel Presages Stronger Copper Prices Surging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue Copper Bull Market Will Continue Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Steel Boom Lifts Iron Ore Prices Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices Global Economic Grwoth Will Boost Copper Prices Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Copper Headed Higher On Surge In Steel Prices Copper Headed Higher On Surge In Steel Prices Chart 6Renewables Dominate Incremental New Generation Copper Headed Higher On Surge In Steel Prices Copper Headed Higher On Surge In Steel Prices Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Physical Deficits Will Draw Copper Stocks... Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low ...Which After Four Years Of Physical Deficits Are Low ...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Copper Headed Higher On Surge In Steel Prices Copper Headed Higher On Surge In Steel Prices Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand Copper Headed Higher On Surge In Steel Prices Copper Headed Higher On Surge In Steel Prices At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Copper Headed Higher On Surge In Steel Prices Copper Headed Higher On Surge In Steel Prices Chart 14 Palladium Prices Palladium Prices     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations 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

Packaging Stocks Are A Buy Packaging Stocks Are A Buy Overweight The niche S&P containers & packaging index is often flying below investors’ radars, but an upbeat global macro picture suggests that an overweight stance is warranted. These neglected materials stocks are a play on rising pricing power due to insatiable demand for containerboard and other packaging materials that the pandemic-driven boom in e-commerce has only exacerbated. Already, intermodal rail carloads that gauge the retail industry’s demand and go toe-to-toe with container and packaging manufacturers’ profits, argue for meaningful upside from current levels (middle panel). Similarly, the CASS freight index that tracks the health of different US freight industries is surging and confirms that relative profits will rebound in the back half of the year (bottom panel). Sector-level operating data are also firming. As we showed in this Monday’s Strategy Report, there is a steep divergence between containers & packaging producer prices and employment with the former outpacing the latter. The implication is that a larger fraction of revenues will reach the bottom line and push relative share prices higher. Bottom Line: We reiterate our overweight stance in the S&P containers & packaging index. The ticker symbols for the stocks in this index are: BLBG: S5CONP– WRK, SEE, IP, AVY, BLL, PKG, AMCR. ​​​​​​​

Highlights Portfolio Strategy Rising demand for packaging materials, increasing industry pricing power along with compelling relative valuations signal that ignored containers and packaging stocks are a hidden gem within the S&P materials sector. Stay overweight. Softening industry activity coupled with an absence of an export relief valve at a time when the economy is on track to fire on all cylinders, compel us to put the S&P soft drinks index on our downgrade watch list.            Recent Changes There are no changes to our portfolio this week. Table 1 Metamorphosis On Temporary Hold? Metamorphosis On Temporary Hold? Feature Equity market euphoria has taken over with the SPX vaulting to fresh all-time highs on numerous occasions over the past two weeks. An easy Fed and ultra-loose fiscal policies remain the key macro drivers of this bull market. While the economy is on track to boom in 2021, leading economic indicators will soon be running into trouble and will have to come off the boil. The ISM manufacturing and services readings are at nose bleed levels, raising some eyebrows of how much further they can rise (Chart 1). The looming $2.4tn infrastructure bill following on the heels of the $900bn and $1.9tn fiscal easing packages since late-December are also likely fully reflected in the exuberant equity prices. As we showed two weeks ago, already more than two Fed hikes are priced in the OIS market over the next 24 months, and four by the end of 2023 (Chart 2)! Chart 1As Good As It Gets As Good As It Gets As Good As It Gets Chart 2Explaining US Dollar Strength Explaining US Dollar Strength Explaining US Dollar Strength S&P 500 twelve-month and five-year forward EPS estimates have crested and so have net earnings revisions (Chart 3). The SPX’s annual rate of change cannot go any higher for the remainder of the year (second panel, Chart 1) and breadth is as good as it gets with both SPX percent of stocks trading above their 50 and 200 day moving averages closing in on 100% (Chart 4).   Chart 3Cresting Euphoria? Cresting Euphoria? Cresting Euphoria? Chart 4Extended Breadth? Extended Breadth? Extended Breadth? The VIX recently melted below 16, junk yields hit all-time lows and the high-yield option adjusted spread multi-year lows (Chart 5). With regard to market internals, looking underneath the SPX hood is revealing. We recently booked handsome gains of 17% in our cyclicals/defensives portfolio bent and moved to the sidelines. This ratio has since ticked down, and so has the small/large ratio. As a reminder, we cemented gains north of 16% early in the year on the size bias and have been neutral since January 12, 2021. Even our long “Back-To-Work”/short “COVID-19 Winners” pair trade has hit a wall and we recently set a 5% rolling stop in order to protect profits of over 20% since our second inception in early February (Chart 6). Chart 5Complacency Reigns Supreme Complacency Reigns Supreme Complacency Reigns Supreme Chart 6Running Out Of Steam Running Out Of Steam Running Out Of Steam Finally, a number of key macro indicators we track are keeping us alert and make us uneasy with the recent stampede into stocks. EURUSD was the first to peak early in January, then gold bullion stalled and finally the South Korean Kospi index peaked. Tack on the recent relative EM stock market underperformance and the risk is that these growth hypersensitive indicators are sniffing out some trouble, potentially an ex-US economic soft-patch. Thus, some caution is warranted until all of these key indicators break out of their recent funk (Charts 7 & 8). Chart 7Three Macro Assets To Closely Monitor Three Macro Assets To Closely Monitor Three Macro Assets To Closely Monitor Chart 8Running Out Of Stimulus Running Out Of Stimulus Running Out Of Stimulus This week we update our SPX dividend discount model (DDM) for the fifth year running, along with the SPX EPS/multiple sensitivity analysis and the SPX forward equity risk premium (ERP). All three ways point to an SPX fair value near 4,050. As a reminder, we have been, and remain, very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2026 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 9). Our 8.2% discount rate mirrors the corporate junk bond yield historical average.  First off, remarkably, the SPX full year 2020 dividend went up 4 cents/share on a year-over-year basis, and blew out even the most optimistic estimates we had last April! While financials chopped their dividends following the Fed’s guidance, the S&P energy sector maintained their dividends as we predicted last spring. Impressively, we posited that XOM and CVX would sustain their dividend aristocrats status (i.e. minimum of 25 consecutive years of rising dividend payouts), which was controversial at the time, and subsequently these two US oil majors diverged from their European peers. Moreover, while a lot of pundits used the GFC as a close parallel, the 9/11 accelerated recession proved the most accurate historical episode from a dividend perspective (bottom panel, Chart 9), and we would not be surprised if a jump in dividend growth similar to the post 9/11 recession takes root. Chart 9Resilient SPX Dividends Resilient SPX Dividends Resilient SPX Dividends Continuing from last year, this year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. Tables 2 & 3 summarize the results. Table 2SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Metamorphosis On Temporary Hold? Metamorphosis On Temporary Hold? Table 3SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Metamorphosis On Temporary Hold? Metamorphosis On Temporary Hold? Table 4SPX EPS & Multiple Sensitivity Metamorphosis On Temporary Hold? Metamorphosis On Temporary Hold? Our own dividend growth estimates result in an SPX 4,050 fair value target (Table 2). Our assumptions are not as pessimistic as the SPX dividend futures, which result in an SPX 2,900 fair value (Table 3, please click here if you would like to receive our DDM and insert your own assumptions). Table 5Forward Equity Risk Premium Analysis Metamorphosis On Temporary Hold? Metamorphosis On Temporary Hold? In order to complement our SPX 4,050 fair value estimate, Tables 4 & 5 highlight our sensitivity analysis and forward ERP fair value estimates. Our starting point is the Street’s $203.1 EPS estimate for calendar 2022 and the backed out SPX forward P/E of 20.3. Similarly, for the forward ERP analysis we use the sell-side’s 2022 EPS estimate along with a forward 10-year US Treasury yield of 2% and an equilibrium ERP near 300bps on the back of: the Fed’s commitment to stay extremely accommodative, melting volatility, collapsing policy uncertainty and soaring ISM manufacturing (Charts 10 & 11). Chart 10Booming Economy… Booming Economy… Booming Economy… Chart 11…Translates Into Melting ERP …Translates Into Melting ERP …Translates Into Melting ERP This dual analysis corroborates the SPX DDM model’s 4,050 fair value and suggests that the SPX is fully valued at the current juncture, leaving little, if any, wiggle room for any mishaps. Our two key macro risks for the remainder of the year remain China’s looming slowdown and the Fed’s tapering, warning that some near-term caution is warranted. This week we update a niche materials subsector and set a downgrade on a consumer staples consumer goods subgroup. Stick With Containers And Packaging Containers and packaging stocks now comprise roughly 13% of the S&P materials index, represent a niche group within a niche sector and were we not already overweight we would not hesitate to commit capital to this index. In a nutshell, Chart 12 captures the attractiveness of container and packaging stocks. These neglected materials stocks are a play on rising pricing power due to insatiable demand for containerboard and other packaging materials. Tack on executives cost discipline and a profit margin expansion story will surprise analysts and investors alike and serve as a catalyst for a durable rerating phase (bottom panel, Chart 12). In more detail, packaged food exports coupled with consumer outlays on food and beverages are soaring. Expanding food manufacturing shipments corroborate this upbeat demand backdrop and signal that the path of least resistance is higher for ultra-pessimistic sell-side analysts’ top and bottom line growth estimates (Chart 13). Chart 12What’s Not To Like? What’s Not To Like? What’s Not To Like? Chart 13Upbeat Demand… Upbeat Demand… Upbeat Demand… Booming intermodal rail carloads gauging the retail industry’s demand also underpin container and packaging manufacturers’ profits (middle panel, Chart 14). Similarly the CASS freight index that tracks the health of different US freight industries is surging and confirms that relative profits will rebound in the back half of the year (bottom panel, Chart 14). Beyond the vigorous recovery in food manufacturing as per the Fed’s latest IP release that is a boon for packaging producers (bottom panel, Chart 15), COVID-19 ramifications also represent a rising source of demand for the industry. COVID-19 has served as an accelerant to the ongoing trend of non-store retail sales grabbing an ever increasing share of total retail sales. As internet sales garner a larger slice of the overall pie, the implication is that demand for boxes and other packaging materials like bubble wrap is increasing at a healthy clip (second panel, Chart 15). Chart 14...Everywhere… ...Everywhere… ...Everywhere… Chart 15…One Looks …One Looks …One Looks Finally, from a world perspective, global export volumes have vaulted to fresh all-time highs (third panel, Chart 15) and global readings of manufacturing PMIs have reached escape velocity. The upshot is that as trade picks up steam and bottlenecks and shortages get resolved likely in the back half of 2021, export volumes will remain buoyant further boosting the allure of container and packaging equities. Netting it all out, rising demand for packaging materials, increasing industry pricing power along with compelling relative valuations signal that ignored containers and packaging stocks are a hidden gem within the S&P materials sector. Bottom Line: Stay overweight the S&P containers and packaging index. The ticker symbols for the stocks in this index are: BLBG: S5CONP– WRK, SEE, IP, AVY, BLL, PKG, AMCR. Put Soft Drinks On Downgrade Alert Soft drinks have taken a beating recently and we are on the lookout for an oversold bounce before we go underweight this consumer goods sub group, thus today we set a downgrade alert. While PEP’s earnings were on the bright side, leading macro indicators signal that investors will be better off to avoid this defensive consumer staples sub-index. Importantly, safe-haven soft drink stocks that tend to be very stable cash flow generators both in good times and in bad, fare worse during the early stages of an economic expansion. As growth transitions from scarcity to abundance, investors start to shed staples exposure including soft drinks (ISM shown inverted, middle panel, Chart 16). Similarly on the operating front, our Beverage Industry Activity Proxy has crested of late and warns that sinking relative profits growth estimates will likely prove accurate (bottom panel, Chart 16). True, sell-side analysts appear to have thrown in the towel on this consumer goods subgroup with both 12-month and five-year forward profit growth estimates plunging to multi-year lows (middle panel, Chart 17). But, relative valuations have followed down the path of this EPS drubbing, and the relative forward P/E ratio is trading 14% below the historical mean (bottom panel, Chart 17). Chart 16Some Yellow Flags Some Yellow Flags Some Yellow Flags Chart 17De-rating Blues De-rating Blues De-rating Blues Actual profits and revenues have made a full circle owing to the sizable jump during the pandemic induced stay-at-home bonanza, however, such a stellar growth repeat remains elusive for 2021. This is especially true if the export relief valve remains firmly closed for the industry. Already there is a sizable gap between the smart rebound in the Asian currency index, but industry exports are still trying to achieve positive year-over-year momentum (Chart 18). The relative tick down in soft drink industrial production (IP), according to the Fed’s latest IP release, corroborates our view that there is an element of stealing demand from the future due to COVID-19, and top line growth will likely surprise to the down side, especially given the soaring reading from the ISM manufacturing survey (ISM shown inverted, bottom panel, Chart 19). Chart 18Export Valve is Blocked Export Valve is Blocked Export Valve is Blocked Chart 19Roaring Economy Weighs On Defensives Roaring Economy Weighs On Defensives Roaring Economy Weighs On Defensives Nevertheless, we are patient before pulling the trigger and downgrading to a below benchmark allocation, as not only technicals are washed out, but also three additional indicators keep us on the sidelines, at least, for now: First, if there is even a mild economic relapse, the 10-year US Treasury yield will be the first to sniff it out and the recent pause in the bond market’s selloff is cause for minor concern (top panel, Chart 20). Second, industry shipments, while a lagging indicator remain resilient (middle panel, Chart 20). Finally, soft drinks pricing power is also robust and there is tentative evidence that beverage producers have been successful in passing on at least part of their rising input costs – mostly commodity related inflation (bottom panel, Chart 20). Netting it all out, softening industry activity coupled with an absence of an export relief valve at a time when the economy is on track to fire on all cylinders, compel us to put the S&P soft drinks index on our downgrade watch list. Bottom Line: Set a downgrade alert on the S&P soft drinks index. The ticker symbols for the stocks in this index are: BLBG: S5SOFD – KO, PEP, MNST. Chart 20But There Are Some Substantial Offsets But There Are Some Substantial Offsets But There Are Some Substantial Offsets   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth

Highlights The Biden Administration's $2.25 trillion infrastructure plan rolled out yesterday will, at the margin, boost global demand for energy and base metals more than expected later this year and next.  Global GDP growth estimates – and the boost supplied by US stimulus – once again will have to be adjusted higher (Chart of the Week). Energy and metals fundamentals continue to tighten. OPEC 2.0's so-far-successful production management strategy will keep the level of supply just below demand, which will keep Brent crude oil on either side of $60/bbl. Base-metals output will struggle to meet higher demand from the ongoing buildout of renewables infrastructure and growing electric-vehicle sales. Of late, concerns that speculative positioning suggests prices will head lower – or, at other times, higher – are entirely misplaced: Spec positioning conveys no information on price levels or direction.  Energy and metals prices, on the other hand, do convey useful information on spec positioning, demonstrating specs do not lead the news or prices, they follow them. Short-term headwinds caused by halting recoveries and renewed lockdowns – particularly in the EU – will fade in 2H21 as vaccines roll out, if the experience of the UK and US are any guide.  Continued USD strength, however, would remain a headwind. Feature If the Biden administration is successful in getting its $2.25 trillion infrastructure-spending bill through Congress, the US will join the rest of the world in the race to re-build – in some cases, build anew – its long-neglected bridges, roads, schools, communications and high-speed transportation networks, and, critically, its electric-power grid.  There's a lot of game left to play on this, but our Geopolitical Strategy group is giving this bill an 80% of passage later this year, after all the wrangling and log-rolling in Congress is done. In and of itself, the infrastructure-directed spending coming out of Biden's plan will be a catalyst for higher US industrial commodity demand – energy, metals and bulks.  In addition, it will support the lift in the demand boost coming out of higher GDP growth globally, which will be pushed higher by US fiscal spending, as the Chart of the Week shows.  Of note is the extremely robust growth expected in India, China and the US, which are among the largest consumers of industrial commodities globally.  Overall growth in the G20 and globally will be expansive in 2022 as well. Chart of the WeekBiden's $2.25 Trillion Infrastructure Bill Will Boost Global Commodity Demand Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Higher GDP growth translates directly into higher demand for commodities, all else equal, as can be seen in the relationship between EM and DM GDP, supply and inventories and Brent crude oil prices in Chart 2.  While we have reduced our Brent forecast for this year to $60/bbl on the back of renewed demand-side weakness in the EU due to problems in acquiring and distributing COVID-19 vaccines, we expect this to be reversed next year and into 2025, with prices trading between $60-$80/bbl (Chart 3).  OPEC 2.0, the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, has done an excellent job of keeping the level of oil supply below demand over the course of the pandemic, which we expect to continue to the end of 2025.1 Chart 2Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Chart 3Brent Crude Oil Prices Will Average - / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 As the Biden plan makes its way through Congress, markets will get a better idea of how much diesel fuel, copper, steel, iron ore, etc., will be required in the US alone.  What is important to note here that the US is just moving to the starting line, whereas other economies like China and the EU already have begun their investment cycles in renewables and EVs.  At present, key markets already are tight, particularly copper (Chart 4) and aluminum (Chart 5).  In both markets, we expect physical deficits this year and next, which inclines us to believe the metals leg of this renewables buildout is just beginning – higher prices will be required to incentivize the development of new supply.2  Chart 4Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Chart 5...As Will Aluminum ...As Will Aluminum ...As Will Aluminum This is particularly important in copper, where growth in mining output of ore has been flat for the past two years.  Copper is the one metal that spans all renewables technologies, and is a bellwether commodity for global growth.  We expect copper to trade to $4.50/lb (up ~ $0.50/lb vs spot) on the COMEX in 4Q21 on the back of increasing demand and tight supplies – i.e., falling mining supply and refined copper output growth (Chart 6). Worth noting also is steel rebar and hot-rolled coil prices traded at record highs this week on Chinese futures markets.  Stronger steel markets continue to support iron ore prices, although the latter is trading off its recent highs and likely will move lower toward the end of the year as Brazilian supply returns to the market.3  We use steel prices as a leading indicator for copper prices – steel leads copper prices by ~ 9 months.  This makes sense when one considers steel is consumed early in infrastructure and construction projects, while copper consumption occurs later as airports and houses are fitted with copper for electric, plumbing and communications applications. Chart 6Copper Ore Output Flat Copper Ore Output Flat Copper Ore Output Flat   Does Speculative Positioning Matter? Of late, media pundits and analysts have cited an unwinding of speculative positions in oil and metals markets following sharp run-ups in net long positions as a harbinger of weaker prices in the near future (Chart 7).4  At other times, speculation has been invoked as a reason for price surges – e.g., when oil rocketed  toward $150/bbl in mid-2008, which was followed by a price collapse at the start of the Global Financial Crisis (GFC).5 Brunetti et al note, "The role of speculators in financial markets has been the source of considerable interest and controversy in recent years. Concern about speculative trading also finds support in theory where noise traders, speculative bubbles, and herding can drive prices away from fundamental values and destabilize markets." (p. 1545) Chart 7Speculative Positioning Lower In Brent Than WTI Speculatives Positioning Lower in Brent Than WTI Speculatives Positioning Lower in Brent Than WTI We recently re-tested earlier findings in our research, which found that knowledge of how specs are positioned – either on the long or the short side of the market – conveys no information on the level of prices or the change that should be expected given that knowledge.  However, knowledge of the price level does convey useful information on how speculators are positioned in futures markets.6 In cointegrating regressions of speculative positions in crude oil, natural gas and copper futures on price levels for these commodities, we find the level of prices to be a statistically significant determinant of spec positions. We find no such relationship using spec positions as an explanatory variable for prices.7 On the other hand, Chart 2 above is an example of statistically significant relationships for Brent and WTI price as a function of supply-demand fundamentals displaying coefficients of determination (r-squares) of close to 90% in the post-GFC period (2010 to now).  This supports our earlier findings regarding spec behavior: They follow prices, they don't lead them.8 We are not dismissive of speculation.  It plays a critical role in markets, by providing the liquidity that enables commodity producers and consumers to hedge their price exposures, and to investors seeking to diversify their portfolios with commodity exposures that are uncorrelated to their equity and bond holdings.  Short-Term Headwinds Likely Dissipate COVID-19 remains the largest risk to markets generally, commodities in particular.  The mishandling of vaccine rollouts in the EU has pushed back our assumption for demand recovery deeper into 2H21, but it has not derailed it.  We expect COVID-related deaths and hospitalizations to fall in the EU as they have in the UK and the US following the widespread distribution of vaccines, which should occur in the near future as Brussels organizes its pandemic response (Chart 8).  Making vaccines available for other states in dire straits will follow, which will allow the global re-opening to progress as lockdowns are lifted (Chart 9). Chart 8EU Vaccination Rollouts Will Boost Global Economic Recovery Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Chart 9Global Re-Opening Has Slowed, But Will Resume In 2H21 Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals The other big risk we see to commodities is persistent USD strength (Chart 10).  The dollar has rallied for the better part of 2021, largely on the back of improving US economic prospects relative to other states, and success in its vaccination efforts.  The resumption of the USD's bear market may have to wait until the rest of the world catches up with America's public-health response to the pandemic, and the global economy ex-US and -China enters a stronger expansionary mode. Bottom Line: We remain bullish industrial commodities expecting demand to improve as the EU rolls out vaccines and begins to make progress in arresting the pandemic and removing lockdowns.  Global fiscal and monetary policy, which likely will be bolstered by a massive round of US infrastructure spending beginning in 4Q21 will catalyze demand growth for oil and base metals.  This will prompt another round of GDP revisions to the upside.  The dollar remains a headwind for now, but we expect it to return to a bear market in 2H21. Chart 10The USD's Evolution Remains Important The USD's Evolution Remains Important The USD's Evolution Remains Important   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 Going into the April 1 meeting of OPEC 2.0 today, we are not expecting any increase in production.  OPEC earlier this week noted demand had softened, mostly due to the slow recovery from the COVID-19 pandemic in the EU, which, based on their previous policy decisions, suggests the producer coalition will not be increasing production.  The coalition led by KSA and Russia will have to address Iran's return as a major exporter to China this year, which appears to have been importing ~ 1mm b/d of Iranian crude this month (Chart 11).  This puts Iran in direct competition with KSA as a major exporter to China, in defiance of the US re-imposition of sanctions against Iranian exports.  China and Iran over the weekend signed a 25-year trade pact that also could include military provisions, which could, over time, alter the balance of power in the Persian Gulf if Chinese military assets – naval and land warfare – deploy to Iran under their agreement.  Details of the deal are sparse, as The Guardian noted in its recent coverage.  Among other things, government officials in Tehran have come under withering criticism for entering the deal, which they contend was signed with a "politically bankrupt regime."  The Guardian also noted US President Joe Biden " is prepared to make a new offer to Iran this week whereby he will lift some sanctions in return for Iran taking specific limited steps to come back into compliance with the nuclear agreement, including reducing the level to which it enriches uranium," in the wake of the signing of this deal. Base Metals: Bullish Copper fell this week, initially on an inventory build, and has now settled right under the $4/lb mark, as investors await details on the US infrastructure bill unveiled in Pittsburgh, PA, on Wednesday.  According to mining.com, a major chunk of the proposed bill will be devoted to investments in infrastructure, which will be metals-intensive.  Precious Metals: Bullish Gold fell further this week, as US treasury yields rose, buoyed by the increased US vaccine efforts and President Biden’s proposed spending plans (Chart 12). USD strength also worked against the yellow metal, which has been steadily declining since the beginning of this year.  COMEX gold fell below the $1,700/oz mark for the third time this month and settled at $1,683.90/oz on Tuesday. Chart 11 Sporadic Producers Will Be Accomodated Sporadic Producers Will Be Accomodated Chart 12 Gold Trading Lower On The Back of A Strong Dollar Gold Trading Lower On The Back of A Strong Dollar     Footnotes 1     Please see Five-Year Brent Forecast Update: Expect Price Range of $60 - $80/bbl, which we published 25 March 2021.  It is available at ces.bcaresearch.com. 2     Please see Industrial Commodities Super-Cycle Or Bull Market?, which we published 4 March 2021 for additional discussion, particularly regarding the need for additional capex in energy and metals markets. 3    Please see UPDATE 1-Strong industrial activity, profit lift China steel futures, published by reuters.com 29 March 2021. 4    See, e.g., Column: Frothy oil market deflates as virus fears return published 23 March 2021. 5    Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), " Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74, for further discussion. 6    Please see Specs Back Up The Truck For Oil, which we published 26 April 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility published 10 May 2018.  Both are available at ces.bcaresearch.com. 7     We group money managers (registered commodity trading advisors, commodity pool operators and unregistered funds) and swap dealers (banks and trading companies providing liquidity to hedgers and speculators) together to test these relationships. 8    In our earlier research, we also noted our results generally were supported in the academic literature.  See, e.g., Fattouh, Bassam, Lutz Kilian and Lavan Mahadeva (2012), "The Role of Speculation in Oil Markets: What Have We Learned So Far?" published by The Oxford Institute For Energy Studies.   Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Biden has enough political capital to pass at least one more major piece of legislation. The next major bill will increase the budget deficit further, adding additional stimulus, though it will consist of structural reforms over a ten-year time frame and with a drag created by tax hikes. Our annual key views are on track: polarization has subsided but remains at peak levels from a historical point of view; structural reform is underway, although any chance of bipartisanship is slipping; the Republicans remain deeply divided despite some signs of regrouping. Investors should remain cyclically bullish although the sharp rise in bond yields, the bounce in the US dollar, China’s growth deceleration, and geopolitical risks all warrant tactical caution in the near term. Feature The first quarter of the year brought a few political surprises – from the Capitol Hill riot to Trump’s second impeachment – but the only significant surprise for the American investor was the Democratic victory in the Georgia Senate runoffs. This victory changed the policy setting, producing a Democratic majority in the US Senate and enabling the Biden administration to project three budget reconciliation bills (for FY2021, 2022, 2023) that require zero Republican votes.  The first of these bills was signed into law promptly as expected. The $1.9 trillion American Rescue Plan Act consists of short-term cash handouts and social spending that will supercharge an economic recovery that is rapidly accelerating due to the rollout of vaccines for COVID-19 (Chart 1). Chart 1American Rescue Plan Boosts GDP Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The second major piece of legislation, likely the budget reconciliation bill for FY2022, will consist of net increases to the budget deficit, thus further stimulating the economy, albeit along with structural reform, i.e. social safety net and tax hikes, and a 10-year time horizon. In the second quarter investors will learn the parameters of the bill through Biden’s address to a joint session of Congress, an idealistic presidential budget proposal, a more realistic House and Senate budget resolution, and an extended negotiation. Yet Biden’s second bill will probably not be signed into law until the third or even fourth quarter. Big Government Is Back The American Rescue Plan Act cements a new era of “Big Government” that should be ascribed not to any particular party but to underlying populist pressures in the United States. President Trump’s big-spending ways and pandemic relief packages had already produced a major step up in the government contribution to economic output, as shown in Chart 2, and this will go higher once Biden’s 8.7% of GDP bill is added to the mix. This increase in the government role is likely to last beyond the pandemic given that President Trump had already taught the Republicans that fiscal austerity does not win votes. Republicans will still be the party of “limited government” but that is a relative concept and they will not be able to win elections on a platform of slashing spending, at least not until stagflation returns. In the meantime they are out of power and tax-and-spend liberals rule the roost. Chart 2Era Of Big Government Is Back Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our updated budget projections show that the decline of stimulus spending will be gradual in the coming years if Biden delivers his second reconciliation bill for FY2022 (Chart 3). Major changes from previous versions have to do with changes to the Congressional Budget Office’s baseline outlook. Our new Democratic Low Spending scenario assumes a $2 trillion dollar green/infrastructure package, a $1 trillion health care reform, and a roughly $2 trillion increase in tax revenue. The Democrats will raise taxes – at least partially repealing Trump’s Tax Cut and Jobs Act and raising a few other taxes. We expect the market to be negatively surprised by the magnitude of tax hikes, at least initially, though the upside risk to the equity market is that tax hikes will be watered down by moderate Democrats in the Senate. We would not bet on a positive tax surprise because even moderate Democrats are in favor of taxing corporations and the wealthy, the taxes can be phased in over a 10-year period, and the economy is on a cyclical upswing combined with mammoth new spending programs. Chart 3US Budget Deficit Booms Under Biden Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our presumption that Biden will sign his second major bill into law this fall (even as late as December) rests on the vulnerability of his administration and party. Traditional Democrats, embodied by Biden, Democratic leaders in Congress, and Biden’s technocratic cabinet (Appendix), face a historic accumulation of political pressure from their populist left-wing and from Trump’s populist Republican Party. If they cannot deliver on major “bread and butter” promises to the American people, while including just enough progressive elements to keep the far left at bay, they risk extinction in coming election cycles. This pressure is real and will enable at least one more major legislative achievement. Bottom Line: Government spending has taken a big step up and Biden’s second major legislative initiative will ensure that the step up is permanent rather than a temporary response to a crisis. The macro impact is inflationary on the margin. Biden’s Second Reconciliation Bill Is the Biden administration over-stimulating the economy and setting the US up for overheating? It looks like it, though the size of tax hikes is as yet unknown. Going forward the stock market will be extremely attentive to two risks that cut in different directions: excessive stimulus and excessive tax hikes. The American Rescue Plan alone is more than twice as large as the estimated output gap. The output gap is widely expected to be closed by the end of the year (Chart 4). Even a $1 trillion infrastructure package – much lower than the currently rumored $3 trillion – would be excessive in this context. Chart 4Output Gap Is Virtually Closed Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The infrastructure package that is being planned – which would include a range of measures in addition to roads and bridges, such as green energy projects, supply chain on-shoring, and digital infrastructure – would take place over a ten-year period and will be coupled with a drag from new taxes. A modern-age infrastructure plan would boost productivity and hence potential GDP growth, which could offset some of the inflationary impact. Speculatively, the simplest path for achieving Biden’s objectives would be to put his health care reform (with other welfare proposals) in the FY2022 reconciliation bill along with tax reform. Tax changes are the purpose of the reconciliation process. Unlike infrastructure, health provisions are virtually guaranteed to pass the arcane rules of reconciliation. This is not a minor concern: the Senate parliamentarian ruled out a federal minimum wage hike in the American Rescue Plan because it was not directly germane to government revenues and expenditures and could do the same to infrastructure. Bear in mind that the Obama administration passed a key component of the Affordable Care Act (Obamacare) via reconciliation, setting a precedent that health care is germane. More broadly the Democratic Party has prioritized health care since 1992, now has a chance to clinch it, and has repeatedly benefited at the ballot box on the health agenda. Infrastructure, unlike health and tax reform, could conceivably pass in a regular bill, or piecemeal in annual spending bills, in which Biden would wheel and deal to try to get 60 votes (50 Democrats, 10 Republicans). However, the latest rumors as we go to press suggest the Democrats will prioritize infrastructure and link it to tax reform. Republicans will not vote for tax hikes so reconciliation would still be required in this case. Reconciliation is trickier with infrastructure spending than with health care, though not impossible. What is clear is that Biden’s agenda is too large to fit into one bill, that tax hikes are being planned, and that reconciliation is necessary for tax hikes. Based on our scenarios in Table 1, every realistic scenario involves an increase to the budget deficit, ranging from around $500 billion to $5.4 trillion over the 10-year period. Therefore the economy will receive additional stimulus on top of the unprecedented peacetime stimulus it has already received. Table 1Scenarios For Biden’s Second Reconciliation Bill Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Two other gleanings from Q1 bear mentioning: Biden’s policies on trade and immigration. On trade, Biden is coopting Trump’s hawkish China policy while trying to improve trade relations with allies and partners. The trade deficit is set to expand along with economic recovery and stimulus, resulting in larger twin deficits (Chart 5). This trend should weigh on the US dollar – but the dollar has strengthened so far this year. Given the US’s inherent strengths – rule of law, innovation, faster relative growth – and the structural rise in global geopolitical tensions, covered regularly by our twin Geopolitical Strategy, we are loathe to bet against a rising dollar. However, investors should note that the BCA House View expects the dollar to relapse and the dollar bear market to continue. On immigration, Biden faces his greatest domestic policy challenge. By easing border and immigration enforcement amid a hyper-charged economic recovery, he has invited a large flow of immigrants and refugees (Chart 6). He is thus forced to take urgent border actions to staunch the flow. If he does what is necessary to maintain order then he will widen the rift with the far left. Meanwhile Republicans are finding an issue over which they can start to reunite. Chart 5US Twin Deficits Balloon US Twin Deficits Balloon US Twin Deficits Balloon Chart 6Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Bottom Line: The air of crisis is dissipating rapidly and proposed tax hikes will motivate opposition but Biden still has enough political capital to get at least one more budget reconciliation bill passed. The bill will focus on health/welfare (easier to pass but more inflationary) or infrastructure (harder but better for productivity). Either way the net deficit impact will be negative and the dual risk of higher taxes and economic overheating will create hurdles for the stock market rally.   Updating Our Three Key Views For 2021 How do the events of Q1 impact our three key views for 2021? At the start of the year we forecast (1) that the US’s political polarization would subside but remain at historically peak levels; (2) that the US would launch major structural reforms, in some cases on a bipartisan basis; (3) that Republican disunity would enable this contradictory environment of polarization yet occasional bipartisanship. Based on the first quarter’s events, we would draw the following conclusions for the second quarter and beyond: 1.   Peak Polarization: Polarization has indeed subsided (Chart 7). The country is still vulnerable to major polarizing events, including domestic extremists of whatever stripe, though any major terrorist attack would likely strengthen support for the sitting government. A fall in polarization is just one positive factor in Biden’s overall political capital, which we measure through our US Political Capital Index (Table 2). We consider Biden’s political capital moderate-to-strong because consumer confidence and the economy will likely improve. However, passing legislation will gradually get harder. The Obama administration had considerably greater strength in the Senate than the Biden administration, though, as mentioned, reconciliation guarantees Biden one or two more major pieces of legislation (Chart 8). Democrats can still overturn the filibuster, which requires a 60-vote majority on regular legislation, as we have long highlighted. But for now they seem to accept a watering-down of the filibuster (a “talking filibuster”) that will still give the minority Republicans the ability to halt controversial legislation. Chart 7Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Table 2Biden’s Political Capital Is Moderate To Strong Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Chart 8Major Legislation Can Pass Early In Presidential Term Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform 2.   Bipartisan Structural Reform: The fact that not a single Republican senator voted for the American Rescue Plan Act, despite the lingering pandemic and air of crisis, suggests that bipartisanship is extremely limited, e.g. limited to the seven Republican senators who voted to convict Trump (Table 3). However, bipartisanship is still possible on an infrastructure package if the Democrats do not link it with tax hikes. Table 3Centrist Senators – And Republicans Who Voted To Convict Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Beneath the surface there is bipartisanship when it comes to trade, supply chains, and countering China. Tariffs bottomed under the Obama administration and Biden started off with another round of “Buy America” provisions and a tentative decision to maintain Trump’s tariffs on China (Chart 9). Measures to boost US supply chain resilience in technology, health, and defense could be rolled up into an infrastructure package to help garner 10 Republican votes. Republicans have prepared for possible compromise by clearing the way for the use of “earmarks,” or constituency-based legislative incentives, otherwise known as pork-barrel spending.  Chart 9Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama The market currently expects an infrastructure bill to pass, as indicated by the outperformance of infrastructure-related stocks, industrials, and materials relative to the market. Our BCA Infrastructure basket is outperforming (Chart 10). The market does not currently expect the Democrats to focus on health care policy, which creates the likelihood of a negative surprise for this sector (Chart 11). Chart 10Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) The managed health care sub-sector (the insurance companies) staged a surprise rally over the past month that should reverse as Biden’s legislative proposals become known. However, Big Pharma and biotech continue to sell off as expected. Again, the simplest FY2022 reconciliation bill would consist of Biden’s health reform plus tax reform. The market is having some doubts about Democrats’ climate change agenda, which will be stuffed into the infrastructure package, given that the US renewable energy index has rolled over relative to global renewables. US cyclicals are also outperforming renewables (Chart 12). If Democrats do not use reconciliation, they may not get many green projects passed. If they do use reconciliation, their health and welfare reforms will have to wait until a FY2023 reconciliation bill that may not get passed. Chart 11More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma Chart 12Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage   3.   Republicans In The Wilderness: Although Republicans have begun to regroup faster than many expected, the divisions within the party have not been healed and will continue to flare up in disputes that threaten to wreck the party. Trump and the populist wing are preparing to put up primary election challengers to establishment Republican senators and representatives who voted against Trump or otherwise who vote against his “America First” agenda. Yet it is possible that 10 Republicans will find it impossible to vote against Biden’s infrastructure package if it is well-designed regarding supply chains and China and not linked with tax hikes. Trump could split the party via his personal following (which may be enhanced by a new social media outlet) and his ability to divide the party’s votes if he forms a “Patriot Party.” We recently showed, via the “Prisoner’s Dilemma” in game theory, that the Republicans must choose a Trumpist agenda of fiscal largesse, trade protectionism, and border security if they are to succeed. Yet Trump may or may not choose to run for president again or form a third party. The result is that Trump is more likely than not to be the Republican candidate in 2024 but there are huge risks to the party’s coherence as the party establishment tries to convince Trump to bow out and support a successor (Diagram 1). The point is that Trump remains a loose cannon and is capable of dividing the party single-handedly. Since investors cannot predict Trump’s behavior they should not expect the Republicans to unite in the near term. Diagram 1Game Theory Says Republicans Will Court Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Bottom Line: Our three key views for 2021 are broadly on track – polarization is subsiding but still near peak levels, structural reform is underway (though bipartisanship is clearly at risk), and the Republicans remain divided and ineffectual. The Democrats’ handling of their infrastructure package will determine if bipartisanship can reinforce structural reform but the FY2022 reconciliation process enables them to achieve some reform regardless. Investment Takeaways The Federal Reserve expects GDP to grow by 6.5% in 2021 as a whole (up from the 4.2% estimate in December) and the unemployment rate to fall to 4.5% by the end of the year (down from 5% previously). Treasury Secretary Janet Yellen is expected to predict full employment by 2022. Households are likely to spend at least a third of the $699 billion in dole money they receive (stimulus checks and topped-up unemployment benefits), according to surveys highlighted by our Global Investment Strategy. This summer will have a party on every block, whether authorized or not. While details are scant about the exact makeup of the Biden administration’s next major legislation, what is clear is that it will have a net negative impact on the budget balance. Democrats will raise taxes but not so much as to jeopardize the economic recovery and their election prospects in 2022-24. This ultra-easy fiscal policy coincides with an ultra-easy monetary policy in which the Fed has insisted it will not raise rates through 2023. The market expects four rate hikes by that time, which would put the Fed funds rate at about 1.1%. The Fed will eventually have to adjust its path for the Fed funds rate and start thinking about thinking about tapering asset purchases. But the main thing to remember is that the Fed has committed to generating an inflation overshoot.   In this context, US investors should be cyclically bullish albeit tactically guarded given the sharp rise in bond yields and rising dollar. A pro-cyclical orientation would favor small caps over large caps, cyclicals over defensives, and value over growth stocks. All of these positions have recently met with some resistance and could face a healthy near-term correction. Cyclical stocks are historically very elevated relative to defensives (Chart 13). But over a 12-month period the recovery and stimulus will reinforce the bullish view, as rising bond yields will not stop equities from rising if the Fed stands pat. Chart 13Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives The chief risks to the pro-cyclical orientation stem from any breakout in the US dollar, the rollover in China’s growth momentum, and the Biden administration’s tax hikes and foreign policy challenges. These risks are all immediate and serious, especially given high stock market valuations. China’s policy tightening will not be fully felt in the economy until the second half of the year and Biden’s specific foreign policy challenges can result in negative geopolitical shocks at any time this year or over the next four years. The point is to buy on the dips unless surprise events fundamentally alter the reflationary cyclical backdrop. With regard to equity sectors, our US Political Risk Matrix highlights the chief policy risks to our US Equity Strategy’s views. Generally speaking Biden poses upside risks to industrials and consumer discretionary sectors and downside risks to energy, health care, tech, and communications (Table 4). After a quarter’s worth of information on markets and policy, these views are mostly confirmed: stay cyclically bullish on industrials and financials, bearish on tech and health care. Table 4US Political Risk Matrix Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform In the case of energy we continue to be neutral-to-bullish over a 12-month time horizon as long as demand is recovering, global inventories are drawing down, and the immediate geopolitical scene is conducive to tit-for-tat attacks in the Middle East, as is the case in the first half of the year. But Biden’s regulatory risks and disruptive climate change agenda can bring negative surprises for US oil producers and Biden’s foreign policy would ultimately be positive for Middle East oil supply. In the case of communications services we are neutral-to-bearish. The Biden administration is allied with Big Tech but it is tightening regulation and anti-trust enforcement gradually to gain greater control over the sector.1 The Treasury selloff is set to continue. Yields are starting to reach pre-COVID levels and have a way to go until they challenge 2018 levels. From peak to trough in the Bloomberg Barclays Treasury Index, the current selloff is not as bad as in the past four recoveries, as our US Bond Strategy has shown. As the economic rebound shows up in hard data over the course of this year, the Fed’s revised expectations will confirm the bond selloff in the financial market. We would thus favor high-yield corporate bonds. We remain overweight TIPS and municipal bonds relative to duration-matched nominal bonds. In recent years presidential approval has correlated remarkably well with the stock-to-bond ratio about two months later (Chart 14). The implication is that higher presidential approval is consistent with receding uncertainty and greater consumer optimism about the economy, which is reflected in rising bond yields and share prices. Neither Biden’s approval rating nor the stock-to-bond ratio is likely to go much higher without a consolidation phase, however, as implied by the chart. Chart 14Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A1BPolitical Capital: Household And Business Sentiment Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform   Table A1CPolitical Capital: The Economy And Markets Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A2Biden’s Cabinet Position Appointments Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Footnotes 1     Biden is expected to nominate anti-trust scholar Lina Khan for FTC commissioner.  

While the Fed’s dots dovishly surprised, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s core PCE price inflation estimate for 2021 to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. The last time the US economy hit such a high mark on a q/q annualized basis (ex-2020) was in late-2003 (Chart 1). Back then the Bush tax cuts were signed into law in late May 2003 turbocharging the economy. Chart 2 shows that the fed funds rate was pegged at 1% and the bond market was in selloff mode, with both the 10-year US Treasury yields surging violently and inflation breakevens galloping higher. While the S&P eventually shrugged off the bond market’s new equilibrium yield, drilling beneath the surface is revealing. Chart 1 Shades Of 2003/4? Shades Of 2003/4? Chart 2 Shades Of 2003/4? Shades Of 2003/4? As a reminder, back then the Fed was actually sowing the seeds of the housing bubble by keeping rates at 1%, which resulted in an economy running on steroids. Deep cyclical sectors outperformed the SPX and defensives significantly lagged the broad market especially as the economic data caught on fire in 2004 (see Appendix Charts A1, A2, A3, ). Financials were range bound and relative tech performance slumped in 2004 (for inclusion purposes Charts A4-A9 in the Appendix also show GICS2 sector relative performance). Bottom Line: Using the 2003/4 parallel as a guidepost we remain comfortable with our current positioning of preferring industrials and energy to consumer staples and communication services. Appendix Chart A1 Appendix Appendix Chart A2 Appendix Appendix Chart A3 Appendix Appendix Chart A4 Appendix Appendix Chart A5 Appendix Appendix Chart A6 Appendix Appendix Chart A7 Appendix Appendix Chart A8 Appendix Appendix Chart A9 Appendix Appendix  

Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact Bearish Trend Intact Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration No Panic From Powell No Panic From Powell This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators Cyclical & Valuation Indicators Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 Market Expects Liftoff In January 2023 Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Financial Conditions Are Easy Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Sector Rotation: Cyclicals Vs. Defensives Sector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Sector Rotation: Banks Vs. Tech Sector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners Sector Rotation: COVID Winners Vs. Re-Open Winners Sector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity Treasury Market Liquidity Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive Reserve Supply Is Massive Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios No Panic From Powell No Panic From Powell If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries.   In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Fed Created ON RRP In 2013... Fed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates ... It Remains A Firm Floor On Rates ... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets The Fed's Maximum Employment Targets The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward.   Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date No Panic From Powell No Panic From Powell This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry No Panic From Powell No Panic From Powell Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification