Money/Credit/Debt

Highlights The ECB is not repressing interest rates and penalizing savers. The Eurozone shows none of the symptoms associated with financial repression. Global excess savings are keeping US rates depressed. If US rates are low, then European rates must be lower because of structural problems in the region’s economy, independent of the ECB’s preferences. Structurally, there is still no case for European yields to rise meaningfully compared to the rest of the world. Despite positive forces over the next year or two, European financials will remain long-term underperformers. European utilities will outperform US ones. The euro is transforming into a safe haven like the yen and the Swiss franc. Feature By maintaining negative short rates, the European Central Bank is conducting severe financial repression, which distorts rates of return and penalizes savers. This is a common refrain among many insurers and pension plan managers investing in Europe and among a large number of the region’s politicians. Chart 1The ECB's Financial Repression? The ECB's Financial Repression? The ECB's Financial Repression? At first glance, this criticism is apt. For the past five years, negative policy rates have forced safe-haven Bund yields to trade well below the Euro Area’s nominal GDP growth (Chart 1). Moreover, the real ECB deposit rate remains well below the Holston, Laubach-Williams estimate of R-star (the real neutral rate of interest). If we go beyond these superficial observations, it is far from clear that the ECB is conducting financial repression or distorting market rates any more than other major global central banks. Is It Financial Repression? The ECB is not conducting financial repression; rather, it is responding to powerful economic forces in Europe and beyond that are depressing interest rates. The definition of financial repression is crucial to this assessment. Financial repression involves monetary authorities actively suppressing interest rates to the advantage of the borrowers and users of capital at the expense of the savers, whose risk-free investments then provide subpar rates of returns. Following this definition, financial repression shows these clear symptoms: A low savings rate. Suppressed interest rates do not adequately compensate savers to forgo consumption. Thus, they are less likely to put money aside. A significant build-up of debt. Real interest rates are below fair market value, which subsidizes borrowing. A significant expansion of the money supply. Money supply expands rapidly in response to strong credit demand in the economy. Plentiful capital expenditures. Savers must take on more financial risk to make appropriate returns on their assets, which compresses risk premia. Depressed internal rates of return boost the net present value of investment projects and thus cause investments to account for a large share of output. A current account deficit. A nation’s current account balance equals its savings minus its investments. By depressing savings and stimulating investments, financial repression results in a current account deficit or a sharply deteriorating current account balance. Above-trend GDP growth. By depressing savings and boosting investments, financial repression lifts cyclical spending and forces the GDP to rise above its potential. The problem for commentators who argue that the ECB is conducting financial repression is that the Euro Area meets none of these criteria. First, Eurozone money and credit growth has run well below that of the US ever since the euro crisis, despite ECB policy rates that are constantly lower than the Fed Funds rate. Moreover, since the ECB cut rates to zero, the pace of money and credit creation has decelerated significantly compared to their pre-crisis trends (Chart 2). Second, the Euro Area’s real GDP per capita, nominal GDP per capita, and the GDP deflator have also fallen 4.6%, 5.2% and 5%, respectively, behind those of the US, since the ECB has cut interest rates to zero (Chart 3). Moreover, the growth of these variables has also decelerated significantly over this period, which is consistent with depressed credit demand. Additionally, despite the inferior performance of European activity metrics compared to those of the US since the introduction of the common currency, European government bonds have performed exactly in line with those of the US (Chart 3, bottom panel) and have therefore outperformed in real terms. This is inconsistent with financial repression by the ECB. Chart 2Europe's Money And Credit Trends Are Too Tame... Europe's Money And Credit Trends Are Too Tame... Europe's Money And Credit Trends Are Too Tame... Chart 3... So Are Output Volume And Price Trends ... So Are Output Volume And Price Trends ... So Are Output Volume And Price Trends Finally, the Euro Area runs a current account surplus of 2.3% of GDP, which has grown by 4.1% of GDP since late 2008. This is the clearest sign that Eurozone savings have become excessive relative to investment, despite the surge in government deficits in the wake of the COVID-19 pandemic. Excess savings are not typically associated with central banks artificially distorting interest rates. Bottom Line: The economic developments in the Euro Area do not correspond to what would be anticipated if the ECB were repressing interest rates. The growth rate of money and credit has structurally slowed both in absolute terms and compared to that of the US. The same deceleration is evident in both real and nominal output per person, as well as in price levels. Finally, the Eurozone’s current account surplus has widened, which highlights that savings have grown in excess of investments. The Eurozone Needs Lower Interest Rates Than The US The ECB must set appropriately low interest rates, if US yields are low across the curve. In a way, the case that the Federal Reserve is conducting financial repression is stronger than the case against the ECB. Over the past twelve years, nominal and real output per capita have grown more robustly in the US, while money as well as credit expansion and inflation have also been stronger. The US runs a persistent current account deficit of 3.1% of GDP, which also indicates that it is not awash in excess domestic savings. Chart 4Maybe The Fed Is Repressing Interest Rates Maybe The Fed Is Repressing Interest Rates Maybe The Fed Is Repressing Interest Rates We could even argue that the case for the Fed repressing interest rates is growing stronger. The federal budget deficit has expanded to 19% of GDP, even as the unemployment rate tumbles (Chart 4). Moreover, US quarterly GDP growth has averaged 8.5% since the fourth quarter of 2020 and, according to Bloomberg consensus estimates, is anticipated to average 6.3% for the remainder of the year. US inflation is also strong. Annual core CPI Inflation hit 3% in April; monthly core inflation was 0.92%, or an annualized rate of 11.6%, the strongest reading in almost 40 years. Yet, even in the US, the argument that the Fed is repressing interest rates is ultimately weak, despite the aforementioned economic strength. The Fed is accommodating global market pressures that are greater than those of the US economy. In other words, even if the Fed did not set short rates, US interest rates would be low across the curve because of global excess savings. Chart 5Too Much Savings, Everywhere Too Much Savings, Everywhere Too Much Savings, Everywhere Excess savings around the world constitute an exceptionally strong gravitational force that anchor global rates at low levels. As Chart 5 shows, since the early 1990s, global private savings have outpaced investments by a cumulative 163% of GDP. Accumulated government deficit, which has accounted for 99% of global GDP, has been far too small to absorb fully this surplus of savings. The resulting imbalance places downward pressure on global inflation (a consequence of demand falling short of supply) and real interest rates, which means it depresses nominal interest rates across the curve. US interest rates also feel the yield-compressing effect of these excess global savings, even if the US economy does not generate excess savings itself (it runs a current account deficit). The major DM central banks are removing a greater proportion of the float of safe-haven from their jurisdictions than the Fed (Chart 6). The resulting scarcity of safe-haven securities means that US fixed-income products remain the natural outlet for global investors seeking safety and liquidity. Thus, despite the US lack of excess savings, Treasury yields have traded below nominal GDP growth 55% of the time over the past 30 years, no matter how strong US activity is or how wide federal deficits become. If the Fed has little choice but to accept low US interest rates, then the Eurozone must accept even lower interest rates because of its large excess savings. As Chart 7 illustrates, the 2-year and 10-year interest rate spreads (both in nominal and real terms) between the Eurozone and the US track the gap between the US current account deficit and the Europe’s current account surplus. Chart 6Treasurys Are The World Only Plentiful Safe-Haven Treasurys Are The World Only Plentiful Safe-Haven Treasurys Are The World Only Plentiful Safe-Haven Chart 7Europe's Excess Savings Justify Lower Rates Across The Curve Europe's Excess Savings Justify Lower Rates Across The Curve Europe's Excess Savings Justify Lower Rates Across The Curve The Eurozone lower rate of return on capital is another force depressing rates relative to the US (Chart 8). This lower return on capital reflects the following structural problems with the European economies: Excess capital stock. The Eurozone peripheral nations have abnormally large capital stocks in relation to their GDPs (Chart 9). As we previously argued, this feature means that Europe suffers from large amounts of misallocated capital, which hurt the return on capital. Chart 8Capital Is Not Rewarded In Europe Capital Is Not Rewarded In Europe Capital Is Not Rewarded In Europe Chart 9Too Much Capital! Too Much Capital! Too Much Capital! Ageing capital stock. Not only is the Eurozone capital stock too large relative to the size of its economy, it is also older than that of the US (Chart 10). An ageing capital stock, especially in a world where ICT spending is one of the key sources of innovation and growth, further hurts the Euro Area’s return on capital. Lower incremental output-to-capital ratio (Chart 11). The Euro Area generates significantly less output per unit of investment than the US. This confirms the notion that capital is misallocated and that it is used less productively than in the US. Chart 10Europe's Capital Is Ageing Too Europe's Capital Is Ageing Too Europe's Capital Is Ageing Too Chart 11Poor Capital Utilization Poor Capital Utilization Poor Capital Utilization Chart 12Europe's Inferior Productivity Problem Europe's Inferior Productivity Problem Europe's Inferior Productivity Problem The final force limiting European interest rates compared to the US is the Euro Area’s inferior potential growth rate. The Eurozone’s population is ageing, and it will start to contract in 2030. Moreover, multifactor productivity growth is weaker than in the US (Chart 12). A lower potential GDP growth accentuates the discount in the Euro Area neutral rate of interest compared to the US. Bottom Line: Despite the relative economic vigor of the US, global excess savings lower US rates across the curve. The ECB has no choice but to accept even lower European rates, because the European economy suffers from greater excess savings than the US: its return on capital is inferior, and its neutral rate of interest is hampered by its lower potential GDP growth. Investment Conclusions For European rates to avoid the fate of Japan and to circumvent suffering many more decades wedged near zero, some important changes must take place. First, at the global level, excess savings must recede. This will allow global interest rates to increase, especially those of the US. Even if Eurozone rates continue to trade at a discount to the US, safe-haven yields in Europe would nonetheless climb in absolute terms. The fall in the global ratio of workers relative to dependent people, most notably in China where the 2020 population census has just highlighted the trend, is one factor pointing toward a potential gradual decline in global savings. For the moment, absorbing excess savings means that global fiscal policy must remain accommodative. Although fiscal authorities around the world continue to display greater profligacy than they did in the wake of the Great Financial Crisis, there is no guarantee that they will not revert to their old ways. In fact, BCA’s Global Investment Strategy service recently showed that the US fiscal policy is set to become more of a constraint on growth next year than it has been in 2020 and 2021 (Chart 13).  One factor to monitor is the international shift in voters’ preferences toward left-wing economic policies, which often results in more generous fiscal spending. If this trend persists, then global fiscal deficits will close more slowly than the private sector savings will decline. This process will both be inflationary over the long run and impose upward pressure on real interest rates worldwide. But the fiscal excesses of the current moment may force opposition parties to restrain spending whenever they come into power. Chart 13Will Global Fiscal Policy Morph Into a Headwind? The ECB Is Not In Charge The ECB Is Not In Charge Second, to narrow the spread between the Eurozone and US interest rates, the Euro Area must tackle its low rate of return on capital. Practically, this means that much of the excess capital stock weighing on European rates of returns must be written down. Doing so will require more cross border mergers and acquisitions within sectors in the Eurozone. However, the loss-recognition process on nonviable capital will be deflationary. Thus, to facilitate these asset write-downs, the region’s fiscal policy and monetary policy must first remain extremely accommodative. It is far from certain that European authorities will resist reverting to their old ways. A structural underweight on European financial equities remains appropriate. Even if the Eurozone enacts the reforms necessary to invite the peripheral asset write-downs required to boost rates of return in the long-run, in the interim, these reforms will be deflationary. Consequently, no matter what, Eurozone yields will remain well below the US for years to come. Moreover, European credit demand is unlikely to outperform the rest of the world for the coming few years. In this context, the RoE of European banks will remain low. Therefore, our current recommendation to overweight this sector is only valid as a near-term play on the global economic recovery and is not a strategic recommendation. By contrast, European utilities will structurally outperform their US counterparts. European utilities offer higher RoE than US ones and have healthier leverage (Chart 14). Moreover, European utilities trade at discounts to US firms on a price-to-book, price-to-cash flow, price-to-sales and dividend yield basis (Chart 15). Additionally, as yield plays, structurally lower European yields relative to those of the US will advantage European utilities on a long-term basis. Chart 14European Utilities Offer More Appealing Operating Metrics... European Utilities Offer More Appealing Operating Metrics... European Utilities Offer More Appealing Operating Metrics... Chart 15... And Are More Attractively Priced Than US Ones ... And Are More Attractively Priced Than US Ones ... And Are More Attractively Priced Than US Ones Finally, the euro will increasingly trade as a safe-haven currency like the yen and the Swiss franc. First, after a decade of trial by fire, EU integration and solidarity have gained rather than lost momentum and the EU break-up risk has proved to be limited to Brexit. Second, although the Eurozone economy is pro-cyclical, so are the Swiss and Japanese economies. Instead, the Euro Area’s structurally elevated savings rate and current account balance are transforming this economy into a net creditor, with a positive net international investment position equal to -0.1% of GDP. Moreover, the bloc’s low inflation will continue to put upward pressure on the euro’s long-term fair value. If we add the Euro Area’s low interest rates to the mix, then the euro is likely to behave increasingly as a funding currency. Thus, while the euro will benefit from the USD’s weakness forecasted by our Foreign Exchange Strategists, it will underperformed more pro-cyclical currencies such as the SEK, the NOK, or the GBP, which do not suffer from the same ills as the Eurozone.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

Highlights Global currencies are at a critical level versus the dollar. From a positioning standpoint today, a break below 89-90 on the DXY index will be extremely bearish, while a bounce from current levels should be capped in the 3-4% range. Two key factors have pushed the dollar down: lower real rates in the US and recovering economic momentum outside the US. There could be some seasonal strength in the dollar as equity markets churn in May. However, this will provide an opportunity for fresh short positions. The Federal Reserve will maintain its resolve to view the current inflation overshoot as transitory, while it will still focus on the labor market. This will keep real rates in the US depressed relative to other countries. New trade idea: Go long CHF/NZD as a play on rising currency volatility. Also sell USD/JPY if it touches 110. Feature Chart I-1The Dollar Is At A Critical Juncture The Dollar Is At A Critical Juncture The Dollar Is At A Critical Juncture After a brief rally from January to March, the dollar is once again on the verge of a technical breakdown. Both the DXY index, the Federal Reserve trade-weighted dollar and EM currency benchmarks are sitting at critical levels (Chart I-1). A breakdown will confirm that the dollar bear market that began in March 2020 remains intact. It will also trigger a flurry of speculative outflows from the dollar. In our December FX outlook,1 our view was that the DXY was headed towards 80 on a cyclical (12-18- month horizon). However, we also predicted the DXY index would hit 94-95 in the first quarter, a view we have reinforced multiple times since then. With the DXY index having peaked at 93.5, it is now instructive to explore the most likely next move. To do this, we will revisit what has changed and what has remained the same since our December piece.  Gauging Investor Positioning Chart I-2Dollar Bulls Are Capitulating Dollar Bulls Are Capitulating Dollar Bulls Are Capitulating Going into 2021, selling the dollar was a consensus trade and the currency was very much oversold. For contrarians, it paid to be bullish (Chart I-2). Since then, investors have closed their short positions on the dollar, shifting their focus to JPY- and CHF-funded carry trades. Speculators are still long the euro, but the magnitude of this bet has declined from a net 30% of open interest to around 10% today. Positioning in GBP and CAD are still elevated, which suggests that these currencies remain vulnerable to a technical pullback.  Interestingly, the Citigroup sentiment indicator for the USD is close to its January nadir. From the vantage point of this gauge, there has been an accumulation of dollar short positions in recent weeks. This helps explain recent dollar weakness. Going forward, positioning will not be particularly useful in dictating the next move in the dollar since it only works well at extremes. Even then, it is only useful for gauging countertrend moves. For much of the early 2000s, sentiment on the dollar was bearish yet rallies were capped at 4-6%. During last decade’s dollar bull market, sentiment remained mostly in bullish territory, but the dollar achieved escape velocity (Chart I-3). Chart I-3The Dollar And Regime Shifts The Dollar And Regime Shifts The Dollar And Regime Shifts From today’s positioning standpoint, a break below 89-90 on the DXY index will be an extremely bearish sign, while a bounce from current levels should be capped in the 3-4% range. This puts the greenback at a critical crossroad in technical terms. The Federal Reserve, Inflation And Interest Rates At the start of 2021, interest rates were moving in favor of the dollar, which continued a trend that has been in place since the middle of last year. The gap between the US and German 10-year yields rose from a low of around 100 basis points last year to a high of over 200 basis points in March. More recently, interest rate differentials have started to move against the dollar, explaining the broad reversal in dollar indices since March. The US-German 10-year spread now sits at 180 basis points. Exchange rates tend to reflect real interest rate differentials, since inflation erodes the purchasing power of a currency. As such, it is important to gauge not only what is happening to nominal rates, but also to underlying inflation trends. This complicates matters because inflation is often a lagging variable, so getting a sense of where inflation is headed can be greatly useful for currency strategy. As a starting point, the US does not rank well when it comes to real interest rates. Chart I-4 shows the broad correlation between real interest rates and the dollar. For low interest rate countries such as Switzerland, Sweden and the euro area, the peak in US real rates also coincided with a cyclical rebound in these currencies. Even for a currency such as the Japanese yen, real rates are favorable compared to the US. Nominal 10-year rates are 10bps and inflation swaps at the 10-year tenor are 23bps. This pins Japanese real rates almost 100bps above rates in the US. Chart I-4AInterest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Chart I-4BInterest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Chart I-4CInterest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Interest Rates Have Moved Against The Dollar Of course, with inflation surprising to the upside in the US, the Fed could taper sooner than they have communicated and/or raise interest rates faster than the market expects. This will not be surprising given other central banks such as the Bank of Canada and the Bank of England have already telegraphed reduced asset purchases. However, even if the Fed does decide to taper its asset purchases, the impact on the dollar will not be as straightforward as some market participants expect. To understand why, consider Chart I-5, which shows that relative to other central banks, the Fed’s balance sheet impulse is already shrinking by approximately 13% of GDP. In essence, the Fed has already been "stealthily" tapering asset purchases compared to other G10 central banks. This action supported the dollar this year. It has also pushed market pricing of the Fed funds rate well above the median dots of the FOMC in 2 years (Chart I-6). Thus the prospect of the Fed tapering asset purchases might already be embedded in the price of assets. Chart I-5Stealth Tapering By The Fed? Stealth Tapering By The Fed? Stealth Tapering By The Fed? Chart I-6Markets Have Already Priced A Hawkish Fed Markets Have Already Priced A Hawkish Fed Markets Have Already Priced A Hawkish Fed Going forward, our Global Fixed Income colleagues have noted that the Fed is already moving down the ladder in terms of who is expected to taper next.2 The Bank of Japan and the European Central Bank have barely tapered their asset purchases. They might not announce anything significant in their June 10 and June 18 meetings respectively, but markets will still be squarely focused on any change in language. Chart I-7A Profligate US Government Has Historically Been Dollar Bearish A Profligate US Government Has Historically Been Dollar Bearish A Profligate US Government Has Historically Been Dollar Bearish If investors decide to take the Fed’s messaging at face value, which suggests that the FOMC will look through any upside surprises in inflation, then real rates will remain depressed in the US—which will pressure the dollar lower. We have little conviction about whether US inflation is transient or more permanent. However, we do know that the US economy is more inflationary than most other developed markets because the US is stimulating domestic demand by much more than is required to close the output gap. Historically, this is a bearish development for the US dollar (Chart I-7). Economic Momentum As A Catalyst To the extent that monetary policy is tailored to suit domestic economic conditions, growth momentum is clearly rotating from the US to other countries. This suggests that the case for other central banks, such as the ECB or the RBA, to follow the steps of the BoE or BoC is rising at the margin. Manufacturing PMIs around the world have overtaken US levels, and it is only a matter of time before the services PMIs catchup. Chart I-8 shows that euro area data continues to surprise to the upside, with the economic surprise index between the euro area and the US at a decade high. This has historically been synonymous with modestly higher Eurozone bond yields relative to the US, which has also provided some support for the currency. The expectations component of both the ZEW and the Sentix surveys came out stronger this month, which confirms that both European and German growth should remain healthy over the summer (Chart I-9). Chart I-8Small Window For European Yields To Rise Small Window For European Yields To Rise Small Window For European Yields To Rise Chart I-9Euro Area Data To Stay Strong Euro Area Data To Stay Strong Euro Area Data To Stay Strong As for the slowdown in Chinese stimulus, we agree it is a risk to global growth as our China Strategists highlight, but two opposing  factors are also at play: Chinese stimulus leads the economy by a long lag. Last cycle, the apex of Chinese credit was in 2016, but it took until 2018 for global trade to slow down (Chart I-10). This partly explains why commodity prices have not relapsed, despite slowing credit creation from their largest buyer. An economy cannot rely on credit formation alone. At some point, the baton has to be passed to the forces of animal spirits. The velocity of money, or how many units of GDP are created for every unit of money creation, is one of these forces. Chart I-11 shows that the velocity of money has been rising faster outside the US, led by China. Chart I-10Chinese Credit Impulse Works With A Lag Chinese Credit Impulse Works With A Lag Chinese Credit Impulse Works With A Lag Chart I-11Money Velocity Versus The US Money Velocity Versus The US Money Velocity Versus The US The above trends give us conviction that any strength in the dollar is a countertrend move that should be faded until the Federal Reserve does a volte face and tightens monetary policy faster than they have telegraphed. A period of weak global growth would constitute another risk to our view. Interestingly, the Chinese RMB has hit new cyclical lows, despite a narrowing of interest rate differentials between the US and China. We suggested in our February Special Report that USD/CNY was headed for 6.2, even if interest rate differentials between the US and China narrowed. If Chinese economic activity is able to stay relatively robust despite slowing credit formation, then USD/CNY will decline further. Chart I-12EM Growth Remains Weak EM Growth Remains Weak EM Growth Remains Weak A break lower in USD/CNY is a necessary but not a sufficient condition for EM currencies to outperform. Relative to the US, EM growth remains worse than at the depths of the COVID-19 recession last year (Chart I-12). Our Emerging Market Strategists reckon a change in economic conditions will be necessary for EM currencies to outperform on a sustained basis. A broadening of the vaccination campaign toward EM countries is likely to hold the key to this change. The Real Risk To Dollar Short Positions The risk from shorting the dollar at current levels comes from the equity market. Developed market currencies have run ahead of the relative performance of their domestic bourses. This is a departure from historical correlations (Chart I-13). A reset in equity markets that favors defensive equities will lead to inflows into the US equity and bond markets, which will hurt DM currencies and buffet the dollar. It is worrisome that this earnings season, the US enjoyed stronger positive earnings revisions. Correspondingly, the US put/call ratio remains very depressed, with complacency reigning across most equity bourses (Chart I-14). Chart I-13ACurrencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Chart I-13BCurrencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Currencies Have Ran Ahead Of Equity Outperformance Chart I-14Lots Of Exuberance In US Stocks Lots Of Exuberance In US Stocks Lots Of Exuberance In US Stocks Chart I-15Equities And The Dollar Have Diverged Equities And The Dollar Have Diverged Equities And The Dollar Have Diverged The nature of a potential market reset is important to consider. For example: Global equities correct, but technology and healthcare lead the drop. In this scenario, the dollar underperforms, as is happening now (Chart I-15) because the US has a heavy weighting in these defensive sectors. The reverse will happen if value stocks or cyclicals lead the drop in global equities. Global equities correct, but bond yields drop as well. The initial reaction will be a stronger dollar as US inflows accelerate, but this will also curb the appeal of the US dollar since Treasury yields will converge towards those of Bunds or JGBs. Moreover, US real rates will collapse even further. We will be sellers of the dollar on strength in this scenario. Global equities correct as yields increase. If US yields lead this rise, the dollar will rally at first, but outflows from the US equity market will also accelerate. If this rotation is durable, the dollar will eventually depreciate, because foreign bourses are highly levered to rising yields. In a nutshell, the US bond market offers attractive yields and the US stock market could behave defensively (as has historically been the case) in a market correction. This creates a risk to shorting the dollar today. Currency Strategy Currency markets are at a critical juncture (Chart I-1) where either a breakdown in the dollar or a countertrend reversal is imminent. Our strategy remains the same it has been so far in 2021. Continue to short the USD against a basket of the most attractive currencies. On this basis, we are already long the Scandinavian currencies. Go short USD/JPY given lopsided positioning. We are placing a limit sell on USD/JPY today at 110. We are also raising our limit buy on the euro to 1.18. It is interesting that the EUR/JPY cross broke out from a multi-year downtrend. This cross has an inverse correlation with the dollar. Buy CHF/NZD today as a play on rising currency volatility. This is a good bet as markets grapple with the next central bank taper policy (Fed versus other DM economies) (Chart I-16). Wait for the equity market correction to play out, after which a green light to short the dollar outright will once again emerge. Historically, May is a good month for the dollar and a volatile one for equities (Chart I-17). That said, dollar bear markets often run in long cycles. Chart I-16Buy CHF/NZD As Insurance Buy CHF/NZD As Insurance Buy CHF/NZD As Insurance Chart I-17The Dollar And Seasonality The Dollar And Seasonality The Dollar And Seasonality   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The recent data out of the US have been mixed: Average hourly earnings improved by 0.7% in April versus March, beating the expected 0.1% increase. Non-farm payrolls increased by 266K in April, far below the expected 978K and 770K in March. The unemployment rate worsened slightly from 6% in March to 6.1% in April, versus an expected improvement to 5.8%.  The NFIB Small Business Optimism survey edged higher to 99.8 in April from 98.2 the prior month. CPI came in at 4.2% year on year in April, outpacing expectations of a 3.6% rise. Month on month, CPI grew by 0.8% in April, crushing the 0.2% consensus. Core CPI came in at 3% year on year in April, beating the expected 2.3%. PPI also surprised to the upside, clocking in at 6.2% year on year in April, versus an expected rise of 5.8%. The US dollar DXY index dropped by 1.3% this week. While CPI surged ahead, employment severely lagged expectations. The Fed’s “maximum employment” target, a gateway to any asset purchase tapering, is unlikely to be reached when the market expects it. This combination of persistent Fed dovishness and potential sizable inflation is bearish for the dollar.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been strong: March German imports strengthened by 6.5% month on month, crushing the expected 0.7%. German ZEW current condition registered at -40.1 in May, far ahead of the -48.8 in April. German ZEW economic sentiment also surprised to the upside in May at 84.4 versus the anticipated 72.  For the entire euro area, the ZEW economic sentiment increased to 84 in May from 66 in April. Sentix investor confidence improved to 21 in May from 13.1 in April, beating the expected 14. Sentix investor expectations climbed to an all-time high of 36.8. The current situation crossed into positive territory for the first time since February 2020. March industrial production was up by 0.1% month on month, lower than the expected 0.7%. The euro strengthened by 1.3% this week against the USD. The uplifting ZEW survey results reinforce our expectation of a global growth rotation in favor of the euro area. While the ECB may not taper asset purchases, a forceful vaccination campaign should lead to further upside data surprises, especially in services. The Euro Area Economic Surprise Index (ESI) remains elevated in contrast with the US ESI, which has declined sharply from its July 2020 peak.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 There was scant data out of Japan this week: Household spending strengthened by 7.2% in March versus February, comfortably beating the expected 2.1% increase. The Japanese current account weakened to JPY 2.65tn in March from JPY 2.9tn in February. The Eco Watchers Survey disappointed in April, with current conditions declining from 49 to 39.1 and the expectations component falling from 49.8 to 41.7. The yen was up by 0.5% against the USD this week. The recent extension of the already months-long state of emergency will put downward pressure on the yen in the near term. However, with Japanese equities and the currency in oversold conditions, we are cautiously optimistic on the yen further along in the year.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data out of the UK have been weak: Construction PMI remained mostly unchanged at 61.6 in April. GDP weakened, quarter on quarter, by 1.5% in Q1. More disappointing was business investment that dropped in Q1 by 11.9% quarter on quarter and 18.1% year on year. March GDP strengthened by 2.1% month on month, suggesting the pullback in the first quarter was mostly due to lockdowns. Manufacturing production was up by 2.1% in March versus February, beating the 1% consensus. The trade deficit narrowed to GBP11.71B in March.  The pound was up by 1.7% this week against the USD. The soft Q1 output data, primarily a result of the winter lockdown, mask improvements in March. With restrictions being lifted, services output and household consumption (induced by excess savings) should quickly catch up with the recent bounce in manufacturing. However, markets may have priced in too much of the UK’s vaccination outperformance as is reflected in the overpriced small-cap equities.   Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The recent data out of Australia have been positive: The NAB Business confidence increased to 26 in April from 17 the prior month. The NAB business survey index also edged higher to 32 in April from 25 in March. Retail sales increased by 1.3% in March month on month, slightly below the expected 1.4%. Quarter on quarter, Q1 retail sales weakened by 0.5% versus the estimated drop of 0.4%. Q1 CPI came in below expectations at 0.6% quarter on quarter and 1.1% year on year. The AUD was up by 1.2% this week against the USD. While the NAB business confidence and conditions indices came in at record highs, the price pressures remain weak in Australia and vaccination progress continues to lag. That said, leading indicators such as capex intentions and forward orders are improving. We are short AUD/MXN mainly to capitalize on Mexico’s proximity to the rebounding US.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The recent data out of New Zealand have been scant: Electronic card retail sales increased by 4% month on month in April after a 0.8% drop in March. The food price index came in at 1.1% month on month in April, compared to 0% in March. The NZD was up by 0.8% this week against the dollar. With positive data coming out of New Zealand recently, our Global Fixed Income Strategy colleagues judge the RBNZ to be the next central bank most likely to taper sometime in the second half of 2021. However, with Q2 inflation expectations that remain soft and the tourism sector still held back by broad border shutdowns, we remain cautious on the kiwi.   Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data out of Canada have been mildly disappointing: The employment report was disheartening. Canada lost 207.1K jobs in April, and the participation rate dropped from 65.2% to 64.9%. The unemployment rate also weakened from 7.5% to 8.1% in April, higher than expected.  The Ivey PMI dropped to 60.6 in April from 72.9 in March, in line with expectations. The CAD was up by 1.35% against the USD this week. Despite the already months-long rallying of the loonie and the housing prices, the CAD is still cheap by its real effective exchange rate. Strengthening oil prices should continue to support the currency. A potential extension to the current COVID-19 lockdown and lagging vaccination progress remain downside risks.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The recent Swiss data have been neutral: Unemployment rate remained relatively unchanged at 3.3% in April, in line with expectations. The Swiss franc was up by 1% this week against the USD. The franc is cheap with a real effective exchange rate that is at one standard deviation below fair value. Should the pickup in global trade continue, this will buffet the franc. However, our bias is that the SNB will continue to fight excessive franc strength, especially against the euro. So we think the franc will lag the euro over the longer term. We are also going long CHF/NZD today should currency volatility pick up.    Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The recent data out of Norway have been mixed: CPI came in at 3% in April, in line with expectations. PPI growth registered at 22.5% in April, year on year. GDP dropped by 0.6% in Q1 quarter on quarter, a disappointment given an estimated 0.4% decrease. Mainland GDP also undershot expectations, decreasing by 1% in Q1 quarter on quarter. The NOK was up by 1% this week against the dollar. The soft Q1 data may hold back the NOK in the very near term, especially considering its remarkable performance since its March 2020 lows. That said, the rally in oil prices will continue to provide support to the NOK. Vaccination progress, on par with that of the euro area, should also benefit the currency.    Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent Swedish data have been mildly positive: The unemployment rate came down from 8.4% in March to 8.2% in April. CPI came in at 2.2% year on year and 0.2% month on month in April, in line with expectations. CPIF registered at 2.5% year on year and 0.3% month on month in April, both beating the consensus. The SEK was up by 2% this week against the USD. Vaccination progress in Sweden is only notches below that of the euro area. A potential shift of sentiment out of the crowded commodity-driven trades could also lend support to the export-driven SEK, on the back of a recovery in Europe in the near term.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019   Footnotes 1     Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2     Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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

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

Highlights Global Tapering: The Bank of England has joined the Bank of Canada as central banks tapering the pace of bond buying. Markets are now trying to sort out who is next and concluding that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. US Treasury Curve: We are adding a new recommended US butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell using US Treasury futures. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime. Feature Heading into 2021, one of our key investment themes for the year was that no major central bank would shift to a less dovish monetary policy stance before the Fed. Not even five months into the year, our theme has already been proven incorrect. Last week, the Bank of England (BoE) announced a slower pace of its asset purchases, following a similar tapering decision by the Bank of Canada (BoC) last month. Chart of the WeekUS Jobs Recovery Lagging, Despite Vaccine Success Who Tapers Next? Who Tapers Next? We had assumed that no central bank could tolerate the currency strength that would inevitably occur by tapering ahead of the Fed. That was clearly not the case in Canada, and the Canadian dollar has already appreciated 4.6% versus the greenback since the BoC taper announcement April 21. The British pound also rallied solidly against both the US dollar and euro immediately after the BoE taper announcement last week. Markets are beginning to speculate on future taper candidates, like the Reserve Bank of New Zealand (RBNZ), with the New Zealand dollar being one of the strongest currencies in the G10 versus the US dollar since the end of March (+4.4%). Investors had been debating the possibility that the Fed could begin tapering sometime in the second half of 2020, largely based on what has to date been a successful US vaccination campaign. Yet while that led to optimism that the US economy can quickly reopen and return to normal, the fact remains that the recovery in US employment from the COVID shock has lagged other major economies (Chart of the Week). The big downside miss on the April US payrolls report highlights how the Fed can be patient before joining the tapering club. US Treasury yields are likely to continue trading sideways, and the US dollar will trade soft, until markets can sort out the true state of US labor demand versus supply. Which Central Bank Could Follow The BoC And BoE? Back in March, we published a report that discussed what we called the “pecking order of global liftoff”.1 We looked at how interest rate markets were pricing in an increasingly diverse path out of the coordinated global monetary easing enacted last year during the COVID recession (Chart 2). We looked at both the timing of “liftoff” (the first rate hike) and the pace of hikes afterward to the end of 2024. We then ranked the countries by the market-implied timing of liftoff. Chart 2Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs Sorting Out The Relative Hawks & Doves Among Global CBs At the time, overnight index swap (OIS) curves were discounting the earliest liftoff from the RBNZ (June 2022) and BoC (August 2022). The Fed was expected to hike in January 2023, followed by the BoE in June 2023 and Reserve Bank of Australia (RBA) in July 2023. The European Central Bank (ECB) and Bank of Japan (BoJ) were the laggards, with no rate hiked discounted until September 2023 and February 2025, respectively. In terms of the pace of rate hikes after liftoff through 2024, our list was broken into two groups. The more aggressive central banks were expected to be the BoC (+175bps), RBA (+156bps), RBNZ (+140bps) and the Fed (+139bps). Much smaller amounts of rate hikes were anticipated from the BoE (+63bps), ECB (+25bps) and BoJ (+9bps). In the two months since our March report, the market timing of liftoff, and the pace of subsequent hikes, has shifted for all those countries (Table 1). The BoC is now expected to move in September 2022, ahead of the RBNZ (October 2022). In 2023, the Fed is now priced for liftoff in March 2023, followed by the BoE and RBA (both in July 2023). The ECB liftoff date is little changed (now August 2023), while the market has dramatically pushed out the timing of any BoJ hike (now November 2025). The cumulative rate hikes through 2024 are moderately lower for all countries except Australia (a reduction in total tightening of 56bps). Table 1The Fed Is Sliding Down The “Pecking Order Of Liftoff” List Who Tapers Next? Who Tapers Next? What is interesting about these changes is that the market has pulled forward the timing of liftoff for the BoE and RBA, while pushing it out for the BoC, RBNZ, BoJ and, most importantly, the Fed. The Fed is now drifting down the “pecking order” for liftoff, expected to lift rates only a couple of months before the BoE or RBA. This is a major change from previous monetary policy cycles, when the Fed would typically be a first mover when it comes to tightening policy. Chart 3The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing The Momentum Of Global QE Has Already Been Slowing While the BoC and BoE decisions to taper quantitative easing (QE) have garnered the headlines, the pace of global central bank balance sheet expansion had already peaked at the start of 2021 (Chart 3). The pace has slowed most dramatically in Canada and the US, but this was a result of certain emergency programs expiring – most notably the Fed’s corporate bond buying vehicles late last year and the BoC’s short-term repo facilities more recently. Greater financial market stability was the reason cited to end those programs, while still leaving government bond QE buying in place unchanged. The year-over-year pace of global QE was set to slow, simply from less favorable comparisons to 2020 after the surge in central bank balance sheet expansion last year. Yet now we are starting to see actual tapering of government bond purchases from some central banks. Is such “early tightening” warranted? Back in that same March report where we discussed the order of global liftoff, we gave our assessment of the most important factors that could drive central banks to consider a shift to a less dovish stance (like tapering). For the BoC, we cited booming house prices and robust business confidence as reasons the BoC could turn less dovish sooner (Chart 4). For the BoE, we noted a sharper-than-expected recovery in domestic investment and consumer spending, as the locked-down UK economy reopens, as reasons why the BoE could begin to tweak its policy settings. For both central banks, all those indicators were mentioned as factors leading to their decision to taper. For the Fed, we determined that rising inflation expectations and increasing labor market tightness would both be required for the Fed to turn less dovish. Only inflation expectations have reached that goal, with the US Employment/Population ratio still well below the pre-pandemic peak (Chart 5). For the RBA, we looked solely at realized inflation measures, as the RBA has explicitly noted that Australian wage growth must rise sustainably towards 3% - nearly double current levels - before realized CPI inflation could return to the 2-3% target range. For both the Fed and RBA, the necessary conditions for a change in current policy settings have not yet been met. Chart 4What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching What The More Hawkish CBs Are Watching Chart 5What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching What The More Dovish CBs Are Watching For the ECB, we noted that realized inflation (and the ECB’s inflation forecasts), along with the Italy-Germany government bond spread as a measure of financial conditions, were the most important indicators to watch before the ECB could consider any move to taper its QE programs (Chart 6). Italian spreads have widened a bit in recent months, while the latest set of ECB economic forecasts still call for headline euro area inflation to remain well south of the 2% target out to 2023. For the BoJ, we simply cited a rise in realized inflation as the only possible development that could lead to a BoJ taper. The BoJ now forecasts that Japanese inflation will not reach the 2% central bank target until at least 2024. So for both the ECB and BoJ, the conditions do not warrant any imminent tapering of bond buying. Chart 6What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching What The Most Dovish CBs Are Watching As another way to determine who could taper next, we turn to our Central Bank Monitors, which are designed to measure the pressure on policymakers to ease or tighten monetary setting. All the Monitors have responded to the recovery in global growth and inflation, along with the easing of financial conditions implied by booming markets, over the past year. Yet only the RBA Monitor is calling for tightening (Chart 7), indicating that the RBA’s current focus on only wages and realized inflation is a departure from their behavior in the past. The Fed and BoE Monitors have risen to the zero line, suggesting no further pressure to ease policy but no tightening is needed either. The ECB, BoJ and RBNZ Monitors are all close, but just below, the zero line, suggesting diminishing need for more monetary stimulus (Chart 8). Chart 7Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Bond Yields Have Moved Ahead Of Our CB Monitors Chart 8Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Yields Overshooting Tightening Pressures Here Too Based on our assessment of the above indicators, we judge the RBNZ to be the next central bank most likely to taper, sometime in the 2nd half of 2021. We still see the Fed starting to signal tapering later this year, but with actual slowing of US Treasury (and Agency MBS) purchases not occurring until early 2022. The year-over-year momentum of bond yields correlates strongly with the Central Bank Monitors. The rise in global bond yields seen over the past year has exceeded the pace implied by the Monitors. This is unsurprising given how rapidly the global economy has recovered from pandemic-fueled recession in 2020. Supply chain disruptions and surging commodity prices have also given a lift to bond yields via rising inflation expectations, even as central banks have promised to keep rates on hold for at least the next couple of years. Yet purely from a monetary policy perspective, the surge in global bond yields looks to have gone a bit too far, too fast. Bottom Line: Markets are now trying to sort out who will taper next after the BoC and BoE, and have concluded that it will not be the Federal Reserve, with US employment still well below the pre-pandemic peak. US Treasury yields will continue trading sideways until there is greater clarity on the pace of US labor market improvement, especially after the big downside miss in the April jobs report. Bond yields in other developed markets appear to have overshot economic momentum, and a period of consolidation is needed before yields can begin moving higher again. US Treasury Curve: How Much Steepening Left? Chart 9A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend A Pause In The UST Bear-Steepening Trend For most of the past year, the primary trend in the US Treasury curve has been one of bear steepening. Longer maturity yields have borne the brunt of the upward pressure stemming from the rapid recovery in US (and global) economic growth from the depths of the 2020 COVID-19 recession. In recent weeks, however, the surge in longer-maturity Treasury yields has stalled, as have the immediate steepening pressures (Chart 9). Purely from a fundamental economic perspective, a steepening Treasury curve is an expected result of the reflationary mix of growth, inflation and monetary policy currently at work in the US. For example, since the 2020 lows, 5-year/5-year forward inflation expectations from the TIPS market have risen 143bps while the ISM manufacturing index surged from a low of 41 to a high of 65 in March of this year (Chart 10). Combine that with the Fed cutting rates to 0% last year, while promising to keep rates unchanged through 2023 and reinforcing that commitment through QE, and it is no surprise to see a steeper US Treasury curve. Chart 10UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation UST Curve Steepening Has Been Driven By Reflation Yet even despite these obvious steepening pressures, the pace of the Treasury curve steepening does seem to be a bit rapid compared to history. In Chart 11, we show a “cycle-on-cycle” analysis, comparing the slope of various US Treasury curve segments (2-year versus 5-year, 5-year versus 10-year, 10-year versus 30-year) to the average of the previous five US business cycles, dating back to the 1970s. The curves are lined up to the start date of the previous recession, with the vertical line in the chart representing that date. Thus, this chart allows us to see how the Treasury curve evolved heading into, and coming out of, economic downturns. Chart 11 shows that the current 2-year/5-year curve, with a steepness of 63bps, is in line with past steepening moves coming out of recession. For the curve segments at longer maturities, the pace of steepening has been much more rapid than in the past. In fact, the current 5-year/10-year slope of 82bps is already above the average past peak level, as is the 10-year/30-year curve of 72bps. If we do the same cycle-on-cycle analysis for the three previous US recessions dating back to 1990, the current curve slopes are more in line with levels seen one year into the economic expansion (Chart 12). During those previous cycles, the curve steepening trend ended around two years into the expansion. This suggests that the current curve steepening could continue into 2022, except for one major difference – the Fed cut rates to 0% very rapidly last year, far faster than in the previous easing cycles. This suggests that additional curve steepening from current levels can only occur through a surge in US inflation. Chart 11Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Current UST Steepening Has Moved Fast Compared To Past Cycles Chart 12Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? Can More UST Curve Steepening Occur With A 0% Funds Rate? The slope of the Treasury curve is typically correlated to the level of the nominal fed funds rate, but is even more strongly correlated to the funds rate minus actual inflation, or the real fed funds rate. When the real funds rate is below the natural real rate of interest, a.k.a. r-star, the Treasury curve has historically exhibited its strongest steepening trend. That can be seen in Chart 13, where we show the real fed funds rate (adjusted by US core CPI inflation) compared to the New York Fed’s estimate of r-star. The gap between the two series is shown in the bottom panel, correlating very strongly to the 2-year/30-year Treasury curve slope. Chart 13Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* Curve Steepening Results When Real Rates Are Below R* With the nominal funds rate at zero, that gap between r-star and the real fed funds rate can only widen in a fashion that would support more curve steepening if a) realized US inflation moves higher or b) r-star moves higher. Both outcomes are possible as the US economic recovery, fueled by expanding vaccinations and fiscal stimulus. Both real rates and r-star are much lower in the current cycle than in previous economic recoveries, although the r-star/real funds rate gap appears to be following a more typical path that suggests potential additional steepening pressure (Chart 14). The wild card in this analysis is the Fed itself. If US economic growth and inflation evolve in way that makes it more likely the Fed would have to begin tapering QE and, eventually, signal future rate hikes, the Treasury curve may shift to a more typical bear-flattening trend seen during tightening cycles. We saw an example of that after the release of the March US employment report, where over a million jobs were created in a single month, causing 5-year Treasury yields to jump higher than longer-maturity Treasuries (i.e. curve flattening). Looking ahead, it appears that the US yield curve is more likely to slowly transition to a bear-flattening/bull-steepening regime than continue the bear-steepening/bull-flattening: trend of the past twelve months. One way to position for this is to enter into butterfly curve trades that offer attractive carry or valuation. For that, we turn to our Treasury curve valuation models. We have been recommending a Treasury yield curve trade in our Tactical Overlay portfolio on page 19, going long a 7-year bullet versus going short a 5-year/10-year barbell (Chart 15). This barbell is now very cheap on our models, which measure value by regressing the butterfly spread on the underlying slope of the curve. In this case, the spread between the 5/7/10 butterfly is unusually wide compared to the slope of the 5/10 Treasury curve. According to our model, this butterfly spread discounts nearly 100bps of additional 5/10 steepening, an excessive amount compared to past cycles. Chart 14R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks R* - Real Funds Rate Gap Below Previous Cyclical Peaks Chart 15Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade Maintain Our Current 5/7/10 UST Butterfly Trade While the valuation is attractive on the 5/7/10 butterfly (Table 2), the carry on this position is a modest 12bps. A butterfly with more attractive carry is the 2/5/30 butterfly. Table 2US Butterfly Strategy Valuation: Standardized Residuals Who Tapers Next? Who Tapers Next? Table 3US Butterfly Strategies: Carry Who Tapers Next? Who Tapers Next? Chart 16Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade Enter A New 2/5/30 UST Butterfly Trade This butterfly has a neutral valuation (Chart 16) on our model, but offers 35bps of carry - the most attractive among all butterflies involving a 5-year bullet (Table 3). With US Treasury yields, and the Treasury curve slope, likely to remain rangebound for the next few months, going for higher carry trades is an attractive strategy – particularly if used in conjunction with a below-benchmark duration stance, which we still advocate. The 2/5/30 butterfly represents an attractive near-term hedge to that more defensive duration posture. Bottom Line: We are adding a new recommended US Treasury butterfly trade to our Tactical Overlay portfolio, going long the 5-year bullet and short the 2/30 barbell. This trade should benefit with US Treasury curve steepening overshooting the pace of past cycles, while offering attractive carry if persistent Fed dovishness slows the cyclical transition to a bear-flattening curve regime.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Who Tapers Next? Who Tapers Next? ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

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

Highlights The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. Feature In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,1 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative The CBO's Fiscal Outlook Is Extremely Negative The CBO's Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit May 2021 May 2021 In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP2 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.3 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,1 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates May 2021 May 2021 In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.4 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs May 2021 May 2021 Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad... Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad... Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control ...With Higher Taxes And Medical Cost Control ...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue The US Government Can Afford To Raise Revenue The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries The US Spends Much More On Health Care Than Other Countries The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs May 2021 May 2021 The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 2 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 3 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 4 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Europe Is Behind The US, But On The Same Path Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Euro Area Hospitalizations Remain High, But Will Soon Decline Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise The Macro Data Continues To Positively Surprise The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve May 2021 May 2021 Chart I-4China's Current Contribution To Global Demand Is Strong China's Current Contribution To Global Demand Is Strong China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? Is Peaking Growth Momentum A Risk For Stocks? Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance May 2021 May 2021 US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Earnings Expectations Already Price In A Normalization In Services Activity Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning India's COVID-19 Situation Is Tragic, And Concerning India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks... Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks... Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last May 2021 May 2021 Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Leading Indicators Of China's Economy Are Pointing Down, Not Up Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels Chinese Interest Rates Have Already Returned To Pre-COVID Levels Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Emerging Markets Have Caused Global Ex-US Stocks To Underperform Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based EM's Underperformance Has Been Broad-Based EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Policy Rate Surprises Tend To Drive The Duration Call Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative The CBO's Fiscal Outlook Is Extremely Negative The CBO's Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit May 2021 May 2021 In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates May 2021 May 2021 In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs May 2021 May 2021 Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad... Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad... Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control ...With Higher Taxes And Medical Cost Control ...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue The US Government Can Afford To Raise Revenue The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries The US Spends Much More On Health Care Than Other Countries The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs May 2021 May 2021 The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights Cryptocurrencies have a long march ahead to be able to displace fiat currencies. While cryptocurrencies are improving tremendously as a medium of exchange, they lag fiat as a store of value and a unit of account. Contrary to popular belief, fiat money has outperformed anti-fiat assets over time as a store of value. Many central banks will replicate the advantages and success of bitcoin through the issuance of central bank digital currencies (CBDCs). Cryptocurrencies are unlikely to disappear anytime soon and can be wonderful speculative investments. However, conservative investors should stick with gold and silver. Feature Chart I-1Spectacular Returns From Cryptocurrencies Spectacular Returns From Cryptocurrencies Spectacular Returns From Cryptocurrencies The rise in the prices of various cryptocurrencies1 has taken many investors by surprise. $1000 invested in bitcoin at the start of 2012 is worth around $10 million today. If you were lucky enough to get in on the first day of trading, when it was worth a fraction of a cent, your initial $1000 investment will be worth around $60 billion today. Meanwhile, many other cryptocurrencies are also sporting legendary returns, not even replicable in the most obscure corners of the options market (Chart I-1). There is some merit to cryptocurrencies, or more specifically, blockchain technology that is the bedrock of their invention. In this decentralized, peer-to-peer system, the need for an intermediary to validate transactions and arbitrate disputes is eliminated. This can greatly reduce transaction costs, especially when compared to banking/legal fees. The autonomy and anonymity that comes with their use is also a desirable feature. For example, anti-fiat enthusiasts welcome the fact that the creation, distribution, and use of cryptocurrencies is outside the purview of central banks. As this asset class continues to garner popularity and capture the imagination of investors, the implications run the gamut from potential future returns (or losses) to the impact on other asset classes. For currency investors, the key question is whether any of these seemingly attractive features have a sizeable impact on the value and use of other developed market currencies. In short, will cryptocurrencies displace fiat? To answer this question, we have to start from the very basic definition of what money is.  Is Bitcoin Money? The three basic functions of money are a store of value, unit of account and a medium of exchange. On at least two of these three basic functions, bitcoin fails. Bitcoin has been improving as a medium of exchange. The ability to swap fiat currency into bitcoins and back is fairly easy. More importantly, more and more merchants are accepting bitcoin as a form of payment. Globally, the turnover of cryptocurrencies is about $200 billion or roughly 3% of overall foreign exchange turnover. This is higher than daily trading in the Mexican peso, the New Zealand dollar, and the Swedish krona, an impressive feat (Chart I-2). This is also evidenced by the rise in the market capitalization of cryptocurrencies, to around $2 trillion today (Chart I-3). Chart I-2An Improving Medium Of Exchange Will Cryptocurrencies Displace Fiat? Will Cryptocurrencies Displace Fiat? Chart I-3Gold Versus Cryptocurrencies Gold Versus Cryptocurrencies Gold Versus Cryptocurrencies However, as Peter Berezin, our Chief Global Strategist has pointed out, this does not necessarily trump the use of fiat money.2  The Visa network, for example, handles over 5,000 times more transactions a second than the bitcoin mempool (the pool of unconfirmed transactions). Meanwhile, if one were to take a vacation in exotic places like Manila or Mumbai, what medium of exchange will one hold? Cryptocurrency, gold or the US dollar? Experience tells us you will be much better off holding greenbacks or even gold. Bitcoin is certainly not a store of value. The drawdown in cryptocurrency prices has been around 80% a year or 40%-50% over three months. This is much more volatile than currencies such as the Turkish lira or Argentinian peso, from countries fraught with political instability and economic fragility (Chart I-4). It appears that the lack of central bank oversight is a vice and not a virtue. Stability in a currency allows for confidence in savings, future purchases, and investment decisions. A monetary system based on cryptocurrencies deprives citizens of this basic tenet.   Chart I-4Bitcoin Is A Poor Store Of Value Bitcoin Is A Poor Store Of Value Bitcoin Is A Poor Store Of Value Bitcoin’s inherent volatility also makes it unsuitable as a unit of account. Prices quoted in bitcoin units will need to be revised daily. Although not a parallel comparison, this is reminiscent of hyperinflationary Zimbabwe, where retail store prices were adjusted several times a day to reflect the rapid depreciation in the currency. This is hardly a monetary regime suitable for the developed world, or any other economy for that matter. In a nutshell, cryptocurrencies do not yet satisfy the basic functions of money. Yes, they are portable, divisible, fungible and in limited supply. However, they have yet to gain wider acceptance, and are not a store of value nor a unit of account. As such, they remain speculative investments rather than money. The Demise Of Fiat Is Exaggerated Even if bitcoin is not money, the question remains whether it should be held in currency portfolios as insurance against fiat money debasement. After all, central bank quantitative easing since the global financial crisis has benefited other monetary assets such as gold and silver. Should investors also accumulate cryptocurrencies? The answer will depend on the type of investor. Dedicated currency investors need not worry about bitcoin. As a starting point, the US dollar very much remains the reserve currency today. About 60% of global reserve allocation is in USD. This position has often been challenged over the last few decades but has never been threatened (Chart I-5). This puts cryptocurrencies a long way from the starting line. Chart I-5The US Dollar Remains King The US Dollar Remains King The US Dollar Remains King It is worth noting that over time, fiat assets have done much better than anti-fiat alternatives. Using Bank of England data from the 19th century, we can see that over time, government bonds did much better than gold, or even stocks and real estate (Chart I-6). The reason is that most currencies provide a yield, while cryptocurrencies and gold do not. Chart I-6Fiat Versus Anti-Fiat Assets Fiat Versus Anti-Fiat Assets Fiat Versus Anti-Fiat Assets Chart I-7The DXY Has Faced Strong Resistance At 100 The DXY Has Faced Strong Resistance At 100 The DXY Has Faced Strong Resistance At 100 If one is worried about the path of the US dollar (like us), there are many other established fiat currencies to choose from. Since 2015, global allocation of FX Reserves to US dollars has fallen from almost 66% to around 60% today. The rotation has favored other currencies such as the Japanese yen, Chinese yuan and even gold (Chart I-7). From a longer-term perspective, this will place a durable floor under developed market currencies. Cryptocurrencies Versus Gold The degree to which cryptocurrencies can benefit from a shift away from dollars will depend on whether private investors or central banks drive the outflows. Central banks have a natural imperative to defend fiat currencies, since these are the very tools they use to implement monetary policy. As such, when diversifying out of dollars, their choice is other fiat currencies or gold, the latter having been a monetary standard for centuries. Private investors, some wanting to cut the cord to a centralized monetary system, may chose cryptocurrencies. Since the peak in the DXY index in 2020, both gold and US Treasuries are down significantly, while bitcoin has catapulted to new highs (Chart I-8). This has occurred because of a change in leadership, where the biggest sellers of US Treasuries have not been official concerns, but private investors (Chart I-9). Foreign central banks still dominate the holding of US Treasuries, to the tune of 60% versus 40% for private investors (bottom panel). But the bulk of outflows has been coming from private investors. Chart I-8Bitcoin Thrives When Mainstream Havens Are Rolling Over Bitcoin Thrives When Mainstream Havens Are Rolling Over Bitcoin Thrives When Mainstream Havens Are Rolling Over Chart I-9A Treasury Liquidation From ##br##Private Investors A Treasury Liquidation From Private Investors A Treasury Liquidation From Private Investors Central banks (the biggest holders of US Treasuries) tend to have stronger hands. This is because central banks are ideological while private investors can be swayed by momentum. For example, China and Russia have a geopolitical imperative to diversify out of dollars. As a result, Russia now has almost 25% of its foreign exchange reserves in gold and China almost 4%. A conservative investor looking to diversify out of fiat currency should naturally choose gold, which is backed by strong buyers. For more speculative investors, a simple rule of thumb could work: Buy cryptocurrencies when they drop 50% and sell when they overtake their previous highs. As we showed in Chart I-3, cryptocurrencies drop at least 40%-50% every year or so, providing ample opportunity to accumulate long positions. It is worth noting that my colleagues have a different approach. Dhaval Joshi, who heads our Counterpoint product, suggests holding cryptocurrencies in inverse proportion to their relative volatility to gold. In other words, given that bitcoin is three times more volatile than gold, your anti-fiat portfolio should have a 25% allocation to cryptocurrencies.3 Peter Berezin, our Chief Global Strategist, will not touch bitcoin. We tend to agree that cryptocurrencies could be a playable mania but would not recommend this asset class for the longer term. Central Bank Digital Currencies   One argument for why cryptocurrencies may not survive over the longer term is that there is a natural limit to how much widespread acceptance they will achieve before central banks start clamping down on them. The first reason will be due to the loss in seigniorage revenue for central banks. Between 2009 and 2019, the US and China generated about $140bn a year in seigniorage revenue (Chart I-10). These are non-negligible sums, which the rapid proliferation of cryptocurrencies threaten. Moreover, as the turnover in cryptocurrencies overtakes global trading in various domestic currencies, many countries are moving to ban bitcoin transactions (Table I-1). Chart I-10Seigniorage Revenue Is Significant Will Cryptocurrencies Displace Fiat? Will Cryptocurrencies Displace Fiat? Table 1A Rising List Of Cryptocurrency Bans Will Cryptocurrencies Displace Fiat? Will Cryptocurrencies Displace Fiat? Second, the use of cryptocurrencies can encourage the proliferation of illegal activities. This is a well-known flaw, and something governments will push back against. Meanwhile, many central banks are moving to establish their own digital currencies. Some of these could be based off the same blockchain technology that underpins bitcoin. This will provide many of the advantages of using a cryptocurrency without some of the known pitfalls. Map I-1 highlights that most G10 central banks have a digital currency plan. Map I-1Many Central Banks Are Planning A Digital Currency Will Cryptocurrencies Displace Fiat? Will Cryptocurrencies Displace Fiat? Some advocates for bitcoin point to its limited supply (21 million coins) as evidence for monetary prudence. Even the gold standard had more flexibility, since gold mining expanded about 2% a year. Yet that still proved to be extremely deflationary. A monetary standard that includes both paper currency and CBDCs provides the flexibility that central bankers need to smooth out economic cycles. A bitcoin-based standard will take us back to the middle ages. Once CDBCs become mainstream, the need for alternative cryptocurrencies will not disappear but fall greatly. This will also happen as the number of cryptocurrencies being created will likely balloon, given the very impressive price rallies in recent years. The IPO of Coinbase, an exchange for trading cryptocurrencies, may have heralded the peak in sentiment. Investment Conclusions The dollar faces many headwinds over the next 12 months. A rebound in global growth that begins to favor non-US economies will benefit pro-cyclical currencies. The Federal Reserve’s liquidity injections have assuaged the dollar shortage that held markets hostage last year. Interest rates are now moving against the dollar. Meanwhile, the greenback is expensive (Chart I-11), with a negative balance of payments backdrop. Chart I-11The US Dollar Is Expensive Will Cryptocurrencies Displace Fiat? Will Cryptocurrencies Displace Fiat? Chart I-12Hold Precious Metals Will Cryptocurrencies Displace Fiat? Will Cryptocurrencies Displace Fiat? Our favorite vehicles to play against coming weakness in the dollar have been the Scandinavian currencies, precious metals and commodity currencies. Within the precious metals sphere, we like both gold and silver but are short the gold/silver ratio as a hedged trade with little downside and much upside (Chart I-12). In particular, precious metals benefit from reserve diversification out of US dollars. In this light, cryptocurrencies could have intermittent rallies. However, given the regulatory and structural issues they face, we will not be holders for the long term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 We use bitcoin and cryptocurrencies interchangeably in this text. We do acknowledge that there are various other cryptocurrencies and these are shown in Chart 1. 2 Please see Global Investment Strategy Special Report, "Bitcoin: A Solution In Search Of A Problem," dated February 26, 2021. 3 Please see Counterpoint Strategy Special Report, "Why Cryptocurrencies Are Here To Stay And Bitcoin Is Worth $120,000," dated April 8, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 March housing starts came in at 1.7 million, versus expectations of 1.6 million. This was a 19.4% month-on-month rise. Building permits were equally strong at 1.8 million for the month of March. The University of Michigan sentiment indicator rose to 86.5 in April from 84.9. The jump in the current conditions component from 93 to 97.2 was noteworthy. Initial jobless claims continue to decline, coming in at 547K for the week of April 17. Existing home sales remained strong at 6 million, even though they fell 3.7% month-on-month. The DXY Index fell by 0.3% this week. Speculators pared back a bit of their bullish positioning on the dollar. The overhang of a risk-off event continues to anchor dollar bulls, but interest rate differentials are now moving against the greenback. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent euro area data have been mixed. The trade balance came in at €18.4 billion in February, versus €24.2 billion the previous month. This supported a current account balance of €25.9 billion. Construction output fell 5.8% year-on-year in February. Consumer confidence came in at -8.1 in April, versus -10.8 in March. The euro rose by 0.3% this week. The ECB kept monetary policy on hold this week, leaving the deposit facility rate at -0.5% and the marginal lending facility at 0.25%. This garnered little market reaction. With a few euro area countries under lockdown, this was the correct stance. Covid-19 will continue to dictate the near-term path of policy and the euro, but we remain bullish longer term. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan have been robust. Exports surged 16.1% year-on-year in March. Imports were also robust at +5.7% year-on-year. This boosted the trade balance to ¥298 billion. Tokyo condominiums for sale are rising 45% year-on-year. Supermarket sales rose 1.3% year-on-year in March. This is a tentative but positive sign of a consumption recovery. The Japanese yen rose 0.6% this week. The yen has been the best performing currency this week, a sign that sentiment was overly bearish and the currency was much oversold. Our intermediate-term indicator remains at bombed-out levels and speculators are still short the yen. This provides further upside for this defensive currency. As a portfolio hedge, we are short EUR/JPY. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 There was an avalanche of positive data from the UK this week. Rightmove house prices came in at 5.1% year on year in April. The labor report was mixed. While the UK lost 73 thousand jobs in February, this was below expectations of a 145 thousand loss. Core CPI came in at 1.1% in March. The RPI index came in at 1.5% year-on-year, in line with expectations. The CBI business optimism survey came in at 38 in April, versus -22 the previous month. Cable rose by 0.4% this week. The UK economy continues to benefit from its strong vaccination campaign. With the prospect of the rest of the world catching up, this trade is now long in the tooth. In short, we are neutral the pound in the short term, but remain bullish longer-term. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was scant data out of Australia this week. The NAB business confidence index came in at 17 in Q1 versus 14 the prior quarter. The Australian dollar fell by 0.6% against the US dollar this week. The Aussie came out of the Covid-19 crisis as one of the best performing currencies, so some measure of consolidation is to be expected. Our intermediate-term indicator continues to blast downward, while sentiment towards the Aussie remains quite elevated. However, we believe that this will be a healthy consolidation in what could prove to be a multi-year bull market in the Australian dollar. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week. CPI came in at 1.5% in Q1, in line with expectations. The Kiwi fell by 0.2% against the US dollar this week. Like Australia, New Zealand has managed the Covid-19 crisis quite well and the new travel bubble between the two countries will help lift economic activity. From a technical perspective however, room for further consolidation in the Kiwi remains. Our intermediate-term indicator continues to drift lower, while speculators are slightly long the cross. In our models, the Kiwi also appears overvalued. We were long AUD/NZD but were stopped out this week for modest profits. We will look to reestablish the trade. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data out of Canada has been quite strong. Foreigners continue to flock into Canadian capital markets, to the tune of C$8.5bn in February. Housing starts came in at 335 thousand in March, the highest since the 70s. The Teranet house price index rose 10.8% year-on-year in March. The CPI release for March was better than expected. Headline was at 2.2%, the core median was at 2.1% and the trimmed mean came in at 2.2%. The Canadian dollar rose by 0.3% this week. The Bank of Canada kept rates on hold, but trimmed asset purchases. This follows a very generous budget from the Liberal party earlier this week. The loonie loved the news and Canadian government bonds sold off. We remain bullish CAD/USD on valuation grounds, spillovers from US fiscal stimulus and a constructive oil backdrop.  Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The recent data out of Switzerland has been quite strong. Producer and import prices fell by 0.2% year-on-year in March. This is a tremendous improvement from the previous 1.1% drop. M3 money supply continues to expand at a robust 5.6% clip. Exports rose 4.5% month-on-month in March. Watch exports surged 37% year-on-year. The Swiss franc rose 0.5% this week. The Swiss franc is the second best performing currency this week after the yen. With US interest rates stabilizing, the rationale for CHF carry trades is slowly fading. Our intermediate-term indicator shows the franc at bombed-out levels, and speculators are still short. This provides some margin for further upside. We are long EUR/CHF, but with very tight stops. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week. Industrial confidence came in at 8.2 in Q1, versus a prior reading of 3.1. The Norwegian krone was flat against the US dollar this week. Norway is setting the tone in terms of what monetary policy and sovereign wealth management could look like for many countries in the coming years. First, the Norges Bank announced they would be testing digital currency solutions over the coming two years. This is the way forward for central banks. Second, the sovereign wealth fund, the biggest in the world, is using its influence to effect policy changes towards the environment. Should the returns from its investments pay off in the years ahead, this could generate powerful repatriation flows for Norway. We are strategically bullish the NOK. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There was no data out of Sweden this week. The Swedish krona rose by 0.2% this week. Swedish 2-year real rates recently punched above US levels, suggesting downward pressure on the krona should soon be abating. Our intermediate-term indicator suggests weakness in the krona is mostly done, while the currency appears cheap in most of our models. The handicap for Sweden is successfully dealing with the pandemic, after having a model that stood apart from what other countries were following. Over the longer-term, we are bullish SEK, just like the NOK, against both the euro and the dollar. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades