Sectors

Highlights EM banks will underperform their DM peers in the next six months due to worsening relative NPL dynamics and shrinking net interest margins. EM banks will either continue experiencing rising NPLs and moribund loan demand due to restrictive lending rates or will have to reduce their lending rates, which will considerably shrink their net interest margins. In both scenarios, EM bank profits will be damaged. Besides, EM is facing an unfriendly macro cocktail of booming US growth and a slowing China. This could cause a capital exodus from EM in the coming months depressing EM currencies and precluding many central banks from cutting interest rates proactively. Feature Chart 1EM vs. DM Banks: More Underperformance Ahead EM vs. DM Banks: More Underperformance Ahead EM vs. DM Banks: More Underperformance Ahead We recommend initiating the short EM banks / long DM banks strategy. There has been a major technical breakdown in EM share prices versus DM peers (Chart 1). When discussing EM banks for the purpose of macro analysis, we separate Chinese, Korean and Taiwanese banks from their EM peers. The basis is that the banking systems in China, Korea and Taiwan1 face different cyclical and structural outlooks than in the rest of EM. Bank assets-to-GDP ratios are much more elevated and the monetary and fiscal policies have more flexibility in China, Korea and Taiwan than in EM. Chart 2Fiscal Thrust In EM And DM Fiscal Thrust In EM And DM Fiscal Thrust In EM And DM Reason #1: Higher NPLs In EM Than DM As a result of the pandemic lockdowns, bank NPLs have surged both in EM and DM. However, DM banks have begun to pare down the NPL provisions they had built over the past year. By contrast, NPLs in EM economies will linger due to persisting economic weakness. In fact, EM banks might need to boost their NPL provisions, further eroding their profits. DM policymakers have provided much more fiscal support to their economies than the governments in EM (ex-China, Korea and Taiwan). The fiscal thrust in these EM economies will be negative in 2021 while it is expected to be positive in the US and neutral in the euro area (Chart 2). Chart 3 shows the fiscal thrust across individual EM economies. The fiscal thrusts in Russia and Brazil are the most negative. In EM (ex-China, Korea, Taiwan), the prime lending rates have declined but are still high both in nominal terms (around 10%) and in real terms (6.5%) (Chart 4, top and middle panels). In our opinion, these levels of prime lending rates are restrictive for EM economies and will both inhibit loan demand and undermine debtors’ ability to service debt. Consistently, bank loan growth remains very muted in EM (ex-China, Korea, Taiwan) (Chart 4, bottom panel). Chart 32021 Fiscal Thrust In Individual EM Countries Short EM Banks / Long DM Banks Short EM Banks / Long DM Banks The pandemic is lingering in several developing countries and their vaccination efforts are trailing those of DM. Consequently, the pace and timing of a full economic recovery in EM will lag those in DM. Chart 5 illustrates that retail sales and auto purchases in EM (ex-China, Korea, Taiwan) remain lackluster. Chart 4EM Bank Lending Rates Are Restrictive EM Bank Lending Rates Are Restrictive EM Bank Lending Rates Are Restrictive Chart 5EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster   Reason #2: Net Interest Margin Squeeze For EM Banks EM banks are facing a dilemma. They have a choice between: continuing to experience rising NPLs and moribund loan demand due to restrictive lending rates, which will also undermine bank profits; and/or significantly reducing their lending rates to spur new lending and to help debtors service their loans. In such a case, their net interest margins and profits will shrink. In a nutshell, the fact that borrowers are struggling despite lending rates being much lower than they have been in the past boils down to underlying productivity and return on capital. Both have downshifted considerably in EM (ex-China, Korea, Taiwan) economies. This was true before the pandemic erupted and is also true at present. Chart 6EM Banks: Net Interest Margin And EPS EM Banks: Net Interest Margin And EPS EM Banks: Net Interest Margin And EPS In brief, the only way for EM banks to avoid escalating NPLs is to reduce lending rates. Yet, the latter will erode their net interest margins and depress their profits. Chart 6 demonstrates that net interest rate margins have been an important driver of banks’ EPS growth and they currently point to weaker bank earnings. Notably, there is little room for EM (ex-China, Korea, Taiwan) central banks to cut their policy/short rates. Doing so could trigger a weakness in their currencies at a time when US growth is booming, and US bond yields are under upward pressure. Overall, any decline in prime lending rates will produce a net interest margin squeeze for banks in EM (ex-China, Korea, Taiwan). In China, authorities have been clear that they expect banks to reduce their lending rates for SMEs even though the central bank does not plan on cutting short-term rates. Such pressure on mainland banks will intensify as growth slows in H2 2021. Hence, Chinese banks are also experiencing a net interest margin contraction. Reason #3: An Unfriendly Macro Cocktail For EM Our major global theme for 2021 is an economic boom in the US and a slowdown in China. Such a global macro dynamic warrants a rebound in the US dollar and a pullback in commodities prices. The US economy will be booming in H2 2021 facilitated by the general reopening of the economy, massive fiscal stimulus, rising employment and income growth as well as the release of pent-up demand for services. The Chinese economy is about to decelerate, as foretold by the rollover in money and credit impulses (Chart 7). China’s slowdown will lead to a decline in commodities prices and EM currencies (Chart 8). Chart 7China Is Set To Slow Down China Is Set To Slow Down China Is Set To Slow Down Chart 8Commodities And EM Currencies Are At Risk Commodities And EM Currencies Are At Risk Commodities And EM Currencies Are At Risk   Finally, one of the best leading indicators for EM EPS has been China’s narrow money growth. Chart 9 demonstrates that the latest rollover in Chinese narrow money growth heralds a slowdown in EM EPS later this year. Chart 9China's Narrow Money Heralds EM EPS Slowdown In H2 China's Narrow Money Heralds EM EPS Slowdown In H2 China's Narrow Money Heralds EM EPS Slowdown In H2 EM’s business cycle is very sensitive to China’s growth because many emerging economies sell to China as much if not more than to the US. An impending slowdown in China will cause a meaningful setback in commodities prices and will depress terms of trade for many EM (ex-China, Korea, Taiwan) economies. In turn, a booming US economy will herald higher US bond yields. Together, these dynamics will likely precipitate a rebound in the US dollar. In sum, such a macro cocktail could cause a capital exodus from EM in the coming months, depressing EM currencies and precluding many central banks from cutting interest rates proactively. As a result, EM local currency bond yields will not fall much, especially in vulnerable EM countries. Chart 10EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise Chart 10 demonstrates that the rise in EM local currency yields (shown inverted on the chart) is typically negative for EM (ex-China, Korea, Taiwan) bank stocks. This is opposite to the dynamics in the US and in Europe where bank share prices rally when bond yields rise. Reason #4: Chinese Bank Stocks Remain A Value Trap Market cap of Chinese bank stocks represents 25% of the MSCI EM bank index. Hence, the performance of Chinese bank share prices contributes significantly to the MSCI EM bank stock index. Chinese commercial banks’ assets have expanded 1.5-fold since early 2009 (Chart 11). The overwhelming part of this expansion has been driven by loan origination, purchases of corporate bonds and various claims on local governments and their affiliated vehicles.  We have written often and at length that there is no link between trends in bank assets and national or household savings. Critically, banks do not intermediate deposits into loans or savings into credit. This holds true in all countries around the world. Following such an epic credit boom in China since 2009, one would typically expect creditors in general and banks in particular to undertake a profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, Chinese banks have not yet sufficiently cleansed their balance sheets and carry a lot of non-recognized bad loans/assets. Investors doubt the quality of the banks’ books. As a result, Chinese banks’ share prices have been in limbo over the last ten years (Chart 12, top panel). Chart 11Chinese Bank Assets: An Epic Boom Chinese Bank Assets: An Epic Boom Chinese Bank Assets: An Epic Boom Chart 12Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan   Provided that this issue of mainland bank asset quality is well known, the government will not allow a full-fledged banking crisis. However, authorities will also not recapitalize banks without current shareholders experiencing losses. Overall, Chinese bank share prices might share the fate of Japanese bank stocks. The latter has been in a secular bear market even though Japan has never had an acute credit crisis (Chart 12, second panel). In a nutshell, Korean and Taiwanese bank share prices have also delivered very poor returns over the past 20 years, even though these banks have not had an acute crisis and the credit-to-GDP ratios in these economies have been rising (Chart 12, third and fourth panels). The upshot is that a rising credit penetration is not sufficient to produce value for bank shareholders. The quality of credit assets, profit margins and the starting points of both equity valuation and bank capital adequacy matter for forward returns on bank stocks. A Word On Bank Stock Valuations Chart 13EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio Even though Chinese bank stocks trade at very low multiples – the price-to-book value (PBV) ratio is presently 0.6, the latter represents a value trap. For comparison, the PBV ratio is 0.5 in Korea and 1.2 in Taiwan. Excluding China, Korea and Taiwan, the EM bank PBV ratio is well below its historical mean (Chart 13). However, this aggregate conceals the wide disparity among EM banks. Chart 14 plots banks’ return on equity (RoE) over the past 12 months on the X-axis and their PBV ratio on the Y-axis. There is a clear positive correlation between RoE and the PBV ratio.   Chart 14A Comparative Valuation Matrix For Global Bank Stocks Short EM Banks / Long DM Banks Short EM Banks / Long DM Banks Combining bank equity valuations and country macro fundamentals, within the EM bank space we favor banks in India, Mexico, Korea, the Czech Republic, Russia (barring a major military conflict in Ukraine) and Singapore. On the other hand, the most vulnerable are bank share prices in Brazil, Peru, Turkey, the Philippines, Malaysia and Indonesia. Concerning Chinese banks, we continue advocating the long large banks/short small and medium bank stocks strategy. The rationale is that a lot of bad news is already discounted in large bank stocks and little in listed small and medium bank stocks. In particular, the PBV ratio is 0.7 for large banks and 1.3 for small and medium banks. More so than large banks, small and medium banks are at risk from the new asset management regulation that will be implemented by the end of this year. Investment Recommendations We initiate a short EM banks / long DM banks position. This is a medium-term strategy for the next six months. This strategy is consistent with our tactical underweight in EM stocks versus DM stocks that we recommended on March 25. From a structural perspective, we continue recommending a neutral allocation to EM within a global equity portfolio. Today we are also publishing a report on India that highlights near-term downside risks to this bourse due to surging COVID-19 cases. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential super-spreader events. As a result, we recommend that asset allocators with less tolerance for volatility tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Chart 15Move Peruvian Stocks From Neutral To Underweight Move Peruvian Stocks From Neutral To Underweight Move Peruvian Stocks From Neutral To Underweight Finally, Peruvian bank stocks have been plunging on the heels of left-wing candidate Pedro Castillo lead in the presidential electionspolls ahead of the second round on June 6th. Chart 15 shows that surging NPLs (shown inverted) herald more downside in bank share prices. Consequently, in the context of political uncertainty, rising NPLs and a potential decline in metal prices, we are downgrading Peruvian equities from neutral to underweight. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 We refer to Taiwan (Province of China) herein in the report as Taiwan.   Equities Recommendations Short EM Banks / Long DM Banks Short EM Banks / Long DM Banks Currencies, Credit And Fixed-Income Recommendations

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Consumption Is Explained By Wages... Consumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks ...Not By Stimulus Checks ...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Stimulus Checks Had No Meaningful Impact On Consumption Trends Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt In Japan, Public Debt Ended Up Paying Down Private Debt In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Tech Is Expensive Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Convert The Earnings Yield Into A Prospective Nominal Return... Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Convert The Earnings Yield Into A Prospective Real Return... Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent ...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather The Rally In Equities Versus Bonds Is Due A Breather The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Underweight The PKR Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Overweight New Zealand Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

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

Gradually, Then Suddenly? Gradually, Then Suddenly? US equity market euphoria got a jab in the arm yesterday and started to test the resolve of late-comers to the rally. While the self-reinforcing cycle of ultra loose financial conditions along with easy fiscal and monetary policies will continue to underpin markets on a cyclical time horizon, any let up in the near-term in any of these buoyant macro forces can have far reaching effects, especially given lofty valuations and rising complacency. Thus, we remain cautious in the short-term. Not only is this market in a desperate need of a breather given that it once again sits two standard deviations above the 20-month moving average (top panel) – a technical signal that allowed us to caution clients of extreme overbought conditions right before the September 2nd correction – but also a number of other factors are waving yellow flags. First, the US smart money flow index is revealing the fragility hidden beneath the SPX surface. The divergence between this index and the S&P 500 is reminiscent of the 2018 “Volmageddon” correction (third panel). Second, the total US equity call / put ratio is significantly diverging with equity prices, likely as a result of both smart money hedging their longs (second panel) and retail call buying frenzy going on a hiatus. Finally, our US Equity Internal Dynamics Indicator also ticked down of late cementing the argument that, for now, equities are fully priced as we posited in yesterday’s Strategy Report where we updated our SPX dividend discount model (bottom panel). Bottom Line: While we remain cyclically bullish, any mishaps on China’s and/or the Fed’s front will likely serve as a catalyst for a near-term correction.  

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

Highlights There are tentative signs that US growth outperformance is ebbing. The recovery in the manufacturing sector abroad is already taking leadership from the US. This trend will soon rotate to the service sector. As such, long-term investors should begin to accumulate the euro on weakness. The Canadian economy is improving faster than our February assessment. This suggests the CAD could outperform sooner rather than later. Feature Chart I-1The Euro Drives The DXY Relative Growth, The Euro, And The Loonie Relative Growth, The Euro, And The Loonie The US economy has been the growth outperformer this year. As such, yields have been rising faster in the US and the dollar has caught a bid. Since the start of the year, the DXY index has retraced 2.5% of its yearly losses against developed market currencies. Meanwhile, the rally has been a broad-based one with the euro, yen and Swedish krona taking the brunt of the decline (Chart I-1). Our bias is that growth outperformance will rotate from the US to the rest of the world later this year. This should hurt the dollar and benefit procyclical currencies. This week, we look at the euro and loonie, two currencies that should benefit from this shift. EUR/USD And The Manufacturing Cycle The relationship between bond yields and the economy is circular. Long bond yields can be regarded as a key signaling mechanism about the growth prospects of an economy. At the same time, bond yields directly affect financial conditions, especially when they rise too far too fast. From the point of view of short-term currency forecasting, determining the tipping point at which rising yields become restrictive could be extremely beneficial in forecasting relative economic growth. Chart I-2 shows that whenever the relative bond yield between the US and the euro area rises by 1%, near-term relative growth subsequently tips in favor of the latter, with a lag of about 12 months. This is important since the correlation between EUR/USD and relative growth is quite strong in the short term (Chart I-3). As such, while the rise in yields between the US and the euro area can hurt EUR/USD in the short term, it will begin to benefit relative euro/US growth in the longer term. Chart I-2Relative Bond Yields And The Manufacturing Cycle Relative Bond Yields And The Manufacturing Cycle Relative Bond Yields And The Manufacturing Cycle Chart I-3Economic Data Is Surprising To The Upside In The Euro Area Economic Data Is Surprising To The Upside In The Euro Area Economic Data Is Surprising To The Upside In The Euro Area Bond Flows And Other Market Signals Despite the increase in US Treasury yields, we have not seen higher European purchases of US bonds this year (Chart I-4). During the dollar bull market from 2011 to 2020, there was a direct correlation between rising US yields and higher Treasury purchases. One difference this time around is that other safe-haven bond markets like Canada, Australia, New Zealand and even the UK, are sporting attractive yields today. US yields have not risen much against other G10 countries in aggregate. This will continue to dent the extent to which the euro can fall. On the flipside, the upside to the euro could be quite substantial. From a purchasing parity perspective, the euro can rise 15% just to reset its discount relative to the US. PPP adjustments tend to take several years, but if the US continues to pursue inflationary policies, then by definition, the fair value of the euro will also rise (Chart I-5). Chart I-4Europeans Have Not Been Increasing Treasury Holdings Europeans Have Not Been Increasing Treasury Holdings Europeans Have Not Been Increasing Treasury Holdings Chart I-5The Euro Remains Slightly ##br##Undervalued The Euro Remains Slightly Undervalued The Euro Remains Slightly Undervalued Other cyclical factors also suggest that the euro could experience a coiled-spring rebound. Copper prices have surged this year and the traditional relationship with the euro has been offside (Chart I-6). While copper is benefiting from a move away from carbon towards cleaner electricity, the euro can benefit as well. European economies have decades of experience in renewable technology and could begin to see meaningful inflows into these sectors once investment capital is deployed. This makes the Bloomberg forecast of EUR/USD at 1.23 at the end of 2022 too pessimistic (Chart I-7). Chart I-6The Euro Could Have A Coiled-Spring Rebound Soon The Euro Could Have A Coiled-Spring Rebound Soon The Euro Could Have A Coiled-Spring Rebound Soon Chart I-7Sentiment On The Euro Has Been Slightly Reset Sentiment On The Euro Has Been Slightly Reset Sentiment On The Euro Has Been Slightly Reset Finally, we are short EUR/JPY as a tactical hedge with tight stops at 131. We are also lifting our limit-buy on the EUR/USD from 1.15 to 1.16. The Canadian Recovery Is Accelerating Chart I-8The Canadian Business Survey Outlook Was Encouraging The Canadian Business Survey Outlook Was Encouraging The Canadian Business Survey Outlook Was Encouraging The Canadian recovery is taking shape faster than our February assessment, which the latest Business Outlook Survey corroborated. Both investment intentions and future sales growth were quite strong, with the former hitting a multi-decade high (Chart I-8). Notably: Two-thirds of firms see sales exceeding pre-pandemic levels; most firms stated that the second wave is having less or no impact to sales, compared to the first; and capacity constraints remain high in certain industries, but overall inflationary concerns remain relatively subdued. The robustness of the survey took us by surprise, given that a second wave of infections is raging, and most of the country is under lockdown. That said, the strength in investment spending is becoming a key theme in a global context, suggesting Canada could see significant FDI flows in the coming years. Markets have started pricing in a faster pace of rate hikes in Canada (Chart I-9). This has been a rare occurrence over the last decade and, together with our Global Fixed Income Strategy colleagues, we still believe there is less of a chance that Canada leads the hiking cycle. However, this could change if momentum in the economy allows it to surpass US growth. Chart I-9Markets Are Pricing In Faster Hikes In Canada Markets Are Pricing In Faster Hikes In Canada Markets Are Pricing In Faster Hikes In Canada The IMF estimates that Canadian real GDP growth will be 5% this year and 4.7% next year. Growth could be much stronger than these levels, according to the Bloomberg Nanos Confidence Index (Chart I-10). Chart I-10Canadian GDP On The Mend Canadian GDP On The Mend Canadian GDP On The Mend The employment report has improved tremendously since our February assessment (Chart I-11). Looking at the sub-components of the BoC Monitor, the weakness was centered on economic variables. This is changing, as the Canadian unemployment rate is falling faster than the US unemployment rate (Chart I-12). That is a bullish development for the CAD. Chart I-11The Canadian Jobs Recovery Is Robust The Canadian Jobs Recovery Is Robust The Canadian Jobs Recovery Is Robust Chart I-12Canadian Employment Catching Up To The US Canadian Employment Catching Up To The US Canadian Employment Catching Up To The US The Canadian housing market is heating up. Overall, house prices are up 10% with many cities well exceeding these levels (Chart I-13). The path for Canadian housing prices has been as follows: government support and macro prudential measures leading to a convergence in prices between low- and high-priced cities. Specifically, Vancouver (and to a certain extent, Toronto) are seeing softer pricing growth, while other cities recover. However, as prices start to deviate away from nominal incomes in lower-priced cities, the risk of wider macro prudential measures greatly increases. The second point is crucial, since the rise in Canadian home prices has been more pronounced than in other countries, such as Australia or the US. This means that both rising indebtedness and falling affordability are likely to present a key macro risk to the Canadian economy. Residential construction is a non-negligible part of the Canadian economy (Chart I-14). Chart I-13The Canadian Housing Market Has Heated Up The Canadian Housing Market Has Heated Up The Canadian Housing Market Has Heated Up Chart I-14Residential Construction Is Booming Residential Construction Is Booming Residential Construction Is Booming Bottom Line: Recent developments are increasing the odds that the Bank of Canada hikes rates sooner rather than later. This will allow further gains in the CAD. The CAD And Oil Crude oil prices are another hugely important driver for the CAD. In fact, for most of this year, interest rates have not been an important factor as the BoC faded any near-term improvement in the Canadian outlook. The Covid-19 crisis together with slow vaccination progress also hurt the recovery, putting the brakes on an appreciating loonie (Chart I-15). Our commodity strategists predict that Brent crude will hit $75 in 2023. This is higher than the forward markets are discounting. Rising forward prices will be synonymous with a higher CAD. However, Canada sells the Western Canadian Select (WCS) blend, which has historically traded at a significant discount to Brent or WTI (Chart I-16). Rising environmental standards hurt Canada, since WCS has a higher sulphur content. Pipeline capacity also remains a major bottleneck to getting Canadian crude to US refineries. Chart I-15The Loonie Has Lagged The Loonie Has Lagged The Loonie Has Lagged Chart I-16Canadian Oil Prices Could Lag The Recovery Canadian Oil Prices Could Lag The Recovery Canadian Oil Prices Could Lag The Recovery The redeeming feature this time around is that the correlation between the CAD/USD and crude oil prices is rising faster than for other currencies, as the US begins to embark on significant infrastructure projects (Chart I-17). Around 50% of US oil imports come from Canada. The Covid-19 crisis also slowed US oil production relative to Canada, which has helped increase the correlation between oil prices and the currency. Portfolio flows into Canada have been accelerating this year, benefitting oil stocks and the loonie. Chart I-17Sensitivity Of USD/CAD To Oil Has Increased Sensitivity Of USD/CAD To Oil Has Increased Sensitivity Of USD/CAD To Oil Has Increased Investment Conclusions Chart I-18The CAD Is Cheap The CAD Is Cheap The CAD Is Cheap The CAD remains cheap. It is trading at one standard deviation below its long-term mean, on a real effective exchange rate basis (Chart I-18). A return to the mean would generate about 10% upside. Our PPP model is less bullish, suggesting the loonie is cheap by about 5%. This still puts 84-85 cents within striking distance. Should the nascent Canadian recovery morph into a genuine acceleration, the CAD could rally even higher.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   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 US economic data has been robust this week:         CPI in March rose 2.6% year-on-year and 0.6% month-on-month, both exceeding expectations. PPI in March came in at 4.2% year-on-year and 1% month-on-month, beating expectations. The Empire Manufacturing survey staged a meaningful rebound from 17.4 to 26.3 in April. Retail sales were particularly strong, coming in at 9.8% month-on-month in March. The NAHB housing market index remained strong at 83 in April.  The DXY Index fell by 0.5% this week. The drop in bond yields was surprising, given robust data. This is likely a signal that bond short positions are becoming a crowded trade. The DXY index is rolling over in April; a trend that supports its seasonal pattern. 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 mildly positive: Retail sales grew by 3% month-on-month in February versus the expected 1.7%. ZEW Economic Sentiment for both Germany and the EU in April came in lower than forecast. Industrial production fell by 1% in February over the prior month. German CPI came in at 0.5% month-on-month, in line with forecasts. The euro rose by 0.5% against the dollar this week, making this a second week of appreciation. The new Covid-19 wave may be a drag on EUR/USD in the near term, but this has also reset sentiment and positioning indicators. Our intermediate-term indicator has rolled over substantially, which is bullish from a contrarian perspective. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 JapaneseYen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Data out of Japan have been mixed: Machinery orders recorded another month of decline, falling by 8.5% month-on-month in February versus an expected 2.8% increase. However, more positively, machine tool orders grew by 65% year-on-year in March. PPI in February came in at 0.8% month-on-month, better than expectations. The Japanese yen rose by 0.4% against the US dollar this week and remains one of the strongest G10 currencies in April. Our intermediate-term indicator has collapsed and speculators are net short the currency. We remain short EUR/JPY as a portfolio hedge. 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 Recent data out of the UK have been mildly positive: February GDP rose 0.4% versus the prior month, slightly falling short of the expected 0.6% rise. Both the industrial and manufacturing production and the construction output exceeded expectations in February, growing at 1%, 1.3%, and 1.6% month-on-month. The trade deficit with the EU increased to 16.4B in February. The British pound rose by 0.3% against the US dollar this week, ranking in the middle among G10 currencies and flat against the Euro. We exited our short EUR/GBP trade last week to take profit on UK’s vaccination success and expected catch up phase for other economies. The elevated net speculative positioning on the pound also makes us neutral.  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 Recent data in Australia were strong: NAB business conditions came in at 25 in March versus 17 in February. The Westpac Consumer Confidence Index for April rose 6.2% month-on-month to 118.8, highest since August 2010.  The labor recovery remains on track. 71K new jobs were added in March versus expectations of 35K. The unemployment rate also fell from 5.8% to 5.6%. The Australian dollar remained flat against the US dollar this week. However, the recent robust data, soaring terms of trade, and high bond yields make AUD/USD a suitable recovery trade. That said, given Mexico’s proximity to the US where recent economic data are strong, we are short the AUD/MXN pair. 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 was scant data out of New Zealand this week: RBNZ held the official cash rate at 0.25% and its asset purchase program steady against a backdrop of a heated housing market, citing uncertainty over the outlook for growth. The NZIERB Business Confidence came in at -13% for Q1 versus -6% in Q4, a first decline in four quarters. The New Zealand dollar remained flat against the US dollar this week. On the day of the rate announcement, NZD rallied while the OIS curve flattened, which is a perplexing development. We believe the OIS curve had the appropriate response. Near term upside risk for Kiwi is the planned travel bubble with Australia. We are long the AUD/NZD. 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 strong: The Bank of Canada Business Outlook Survey was robust. The sentiment indicator recorded 2.87 in Q1, up from 1.3 in Q4 and highest since 2018. The March employment report was blockbuster. There were 303K new jobs versus an expectation of 100K. The split between part-time and full-time was healthy, 175K versus 128K. This brought down the unemployment rate to 7.5% in March, beating both forecasts and the February reading of 8.2%. The Canadian dollar rose by 0.3% against the US dollar this week. We spend some time in the front section discussing the Canadian dollar, which could be a little vulnerable in the short term, but could touch 84 cents in the coming 12-months. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 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 There was scant data out of Switzerland this week: The unemployment reading was 3.3% in March, lower than both the forecast and prior month. The Swiss franc was flat against the US dollar this week, remaining a top performer amongst the G10 currencies in April. As we indicated in last week’s report, the Franc may be due for a rebound after its underperformance in the first three months this year. While the CHF may continue its appreciation against the US dollar, we are long EUR/CHF on valuations concern, but are maintaining tight stops at 1.095. Our USD/CHF intermediate-term indicator is also due for a reversal. 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: GDP in February fell by 0.5% month-on-month. House prices increased by 3.4% quarter-on-quarter in Q1. March CPI came in at 3.1% year-on-year, versus expectations of a 3.4% increase. CPI disappointment was driven mainly by a 0.6% month-on-month decline in consumer goods prices. The Norwegian krone remained flat against the US dollar this week. Despite the Norges Bank’s expected rate hike this year, the earliest amongst the G10 nations, the NOK may see near term downside risks given the weak inflation data this month and the potential weakening in oil prices due to renewed virus lockdowns globally. Strategically we remain long NOK along with SEK for an eventual decline in the dollar.    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 The recent inflation data out of Sweden have been strong: The CPIF measure, favored by the Riksbank, rose 1.9% year-on-year versus the 1.5% increase in February. The rise was only was 1.4% ex-energy, but most inflation measures have rebounded powerfully from the 2020 lows. The Swedish krona, up by 1.4% against US dollar this week, was a top performing G10 currency both this week and in April. The 5-year and 10-year inflation swaps remain well anchored above the 2% level, suggesting markets are not regarding the increase in Swedish inflation as transitory. This could bring forward rate hike expectations. The higher 2-year real yield in Sweden versus US, due to higher US inflation, will also support the SEK. However, new Covid-19 cases remain a concern. 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

Set A Downgrade Alert On Financials Set A Downgrade Alert On Financials One week following the Pfizer/BioNTech vaccine efficacy news, we boosted the S&P financials sector to overweight and since then financials have bested the SPX by 13%, an impressive run. However, the euphoria surrounding the reopening trade, which the bond market’s sell off best captures, has hit a wall of late, and not only have yields settled lower, but financials stocks have also come off the boil (top panel). Given that financials equities represent the nervous system of the US economy this soft-patch raises the question: is this a genuine pause for breath or have relative share prices already discounted all the good news including the third mega fiscal package announced over the past four months? What is slightly unnerving is that other high frequency economic reopening indicators also wave yellow flags. The value/growth style bias has fallen to a level consistent with a 10-year US Treasury yield near the early January 1.10% breakout level, the small/large size bias has made a mini lamda (Λ) formation and even our long “Back-To-Work”/short “COVID-19 Winners” pair trade is grinding lower (second, third & bottom panels). While the jury is still out, we want to lean on the side of caution and protect handsome profits accrued to our portfolio since the mid-November inception, and thus put the sector on our downgrade watch list and set a trailing stop at the 10% return mark. Bottom Line: Put the S&P financials sector on downgrade alert and set a trailing stop at the 10% return mark. Stay tuned.  

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Upside Oil Price Risks Are Increasing Upside Oil Price Risks Are Increasing Chart 2DM Demand Surges This Year DM Demand Surges This Year DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort Shale Is The Marginal Barrel In The Price Taking Cohort Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Supply-Demand Balances in 2021 Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Upside Oil Price Risks Are Increasing Upside Oil Price Risks Are Increasing We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... OPEC 2.0 Policy Continues To Keep Supply Below Demand... OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 OECD Inventories Fall to 2023 OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Brent Forecasts Rise As Global Economy Recovers Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   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 and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Base Metals Are Being Bullish Base Metals Are Being Bullish Chart 10Gold Prices To Rise Gold Prices To Rise Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Critical Condition Critical Condition Underweight (High-Conviction) Pharmaceutical stocks are melting in line with the broader macro-economic rebound, and given our cyclical and structural bullish market outlooks, we continue to recommend investors fade this defensive sector (CLI and ZEW shown inverted, middle & bottom panels). JNJ’s recent negative blood clotting vaccine news further accelerated the wholesale liquidation of this key health care sub-group. Should the number of vaccine-caused fatal cases rise, more and more countries will be banning this US-manufactured vaccine, putting additional earnings strains on drug stocks. As a reminder, we are currently underweight the S&P pharma index both within our cyclical and high-conviction universes and the positions are up 12.4% and 10%, respectively. Bottom Line: Stay underweight the S&P pharma index. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, VTRS, PRGO.  

Highlights Biden will host a global summit for Earth Day on April 22-23, giving public attention to his climate change policy push. Investors should count on Biden’s green infrastructure package becoming the bulk of his climate push, given uncertainty over the 2022 midterm elections. However, over the long run, American public opinion is shifting in favor of renewables and the US will seek to maintain its technological edge via participating in the green tech race. Go long our “Biden Fiscal Advantage Basket” versus the Nasdaq 100.  Feature The Biden administration’s $2.3 trillion American Jobs Plan is often referred to as a “green infrastructure” package and in this report we take a look at what makes it green – and what are the investment implications. Biden will virtually host a global climate summit on April 22-23, Earth Day, which the Chinese President Xi Jinping is expected to attend, thus providing momentum to the green investment theme. The stock market anticipated Biden’s electoral victory last year and renewable energy stocks rallied exorbitantly, with ultra-easy monetary and fiscal policy as a fundamental support. The market’s reaction to Biden’s official outline of his plan last month suggests that investors are energized about Biden’s infrastructure package but already suffering from some green fatigue (Chart 1). However, this bill’s passage will initiate the US’s official entrance into the global green energy race and from that point of view renewable plays should recover. Once the American Jobs Plan passes, likely sometime this fall, Biden’s climate agenda will be virtually finished, from an investment perspective. Investors have little visibility beyond 2022 as the president’s party rarely hangs onto the House of Representatives in his first midterm election. However, over the long run, American public opinion is shifting in favor of renewable energy. And Biden also has regulatory tools to push the Democratic Party’s climate agenda from 2022-24 regardless. Chart 1Biden's AJP Already Priced Biden's AJP Already Priced Biden's AJP Already Priced Chart 2Biden’s First Budget: Boom In Non-Defense Discretionary Spending Biden's Green Initiatives Biden's Green Initiatives Biden’s first presidential budget, released on April 13, also highlights the US’s attempt to boost climate policy (the Environmental Protection Agency’s funding would go up by 21%). More broadly it highlights the US’s ongoing sea change in fiscal policy. Discretionary spending turned around under President Trump’s populism and will continue under Biden’s populism. The difference lies in social spending versus defense. Biden proposes a 15.2% increase in non-defense discretionary spending, with education, commerce, health, and environment while the departments of defense and justice see much smaller increases (Chart 2). But we doubt that even defense spending will be curtailed given the US’s global strategic challenges. The president’s budget proposals are drops in the bucket compared to the trillions in his economic stimulus packages. Biden’s American Family Plan will be outlined in detail later this month but it only has a 50/50 chance of passing by the 2022 midterm election. This leaves us with the American Jobs Plan as the real macro policy factor to watch. And in the case of green energy, in particular, the Democrats may not have another opportunity to pass major legislation for many years. The US’s Strategic Basis For Green Energy The American Jobs Plan is billed as a $2.3 trillion green infrastructure package but in reality the package should be broken into traditional infrastructure ($784 billion for roads and bridges), social welfare ($647 billion  for elderly care, education, etc), green initiatives ($370 billion for electrical grid and retrofits, etc), tech initiatives ($280 billion for broadband, semiconductors, research and development), and small business support, in order of dollar value (Chart 3). The implication is that climate policy is important but not the top priority. Still, $370 billion is the biggest green package the US has ever launched. It consists of $150 billion for “hard” green infrastructure, such as new electricity grid and $220 billion for “soft” green infrastructure, such as tax credits for buying EVs (Chart 4). Chart 3Biden’s AJP: Green Initiatives Total $370 Billion Biden's Green Initiatives Biden's Green Initiatives Chart 4Biden’s AJP: Green Initiatives Mostly Rebates/Incentive Biden's Green Initiatives Biden's Green Initiatives The US has moved slowly on green energy policy – relative to Europe or China – because it does not face the same strategic necessity. China faces domestic social unrest if it does not reduce pollution, it faces American strategic containment if it does not reduce its dependency on the Middle East (35% of total oil consumption), and it faces the middle-income trap if it does not increase innovation and productivity. Europe is similarly dependent on a geopolitical enemy for its energy supply – Russia provides 35% of its oil consumption and 38% of its natural gas – and it must also increase productivity. Europe and China are net energy importers who have a great strategic interest in making energy supply a matter of manufacturing prowess rather than divine natural resource endowment (Chart 5). The US is late to the green energy game in part because it does not share the same degree of strategic necessity. Like the EU, the US took care of its most pressing pollution problems decades ago. But unlike the EU, the US is a net energy exporter thanks to the fracking revolution. However, the US is not truly energy independent – an Iranian closure of the Strait of Hormuz would cause global oil prices to spike and trigger a recession. And the US also has a powerful strategic interest in maintaining its global leadership and its edge in technology, innovation, and productivity (Chart 6). The US cannot afford to miss out on the green tech race even if starting from a more secure natural resource base. Chart 5US Green Focus Less Motivated By Energy Security Than China, EU Biden's Green Initiatives Biden's Green Initiatives US public opinion is also following European opinion regarding climate change and environmental protection. True, voters are more urgently concerned about the economy, jobs, and health care over the environment – as we showed in our Special Report on health care earlier this year. But the administration has decided not to rehash the health care battles of the Obama administration – having seen Republicans fail to repeal Obamacare – and instead to open up a new policy domain with climate change. Even if the environment is low priority for most voters, they do not oppose green projects in principle – in fact, they favor renewable energy over fossil fuels when it comes to the US’s energy future (Chart 7). And voters strongly favor infrastructure, which means they are more susceptible to green energy projects when presented as part of a broader infrastructure buildout – as opposed to a transformative “Green New Deal” designed to revolutionize every aspect of US life. Chart 6US Green Focus Motivated By Global Innovation/Tech Race Biden's Green Initiatives Biden's Green Initiatives Chart 7US Public Supports Renewable Energy Biden's Green Initiatives Biden's Green Initiatives The US shift to green energy is well underway, with renewables ready to surpass coal in the national energy mix (Chart 8). The natural gas boom of the past decade has worked wonders in reducing coal dependency and hence overall carbon emissions (Chart 9). Chart 8Shift To Renewables Well Underway Biden's Green Initiatives Biden's Green Initiatives Chart 9US Carbon Emissions To Fall Further Biden's Green Initiatives Biden's Green Initiatives Bottom Line: The US does not have the same energy security problems as China and the EU, which is one reason the US trails these competitors in green energy production and policy. But the US has a powerful interest in maintaining its technological edge and productivity growth. So policymakers will continue to push the green agenda even as the public follows Europe in becoming more favorable toward it over the long run. US Climate Policy Will Advance In Fits And Starts The fact that the US lacks the same strategic urgency as Europe and China suggests that the green energy push in the US will progress in fits and starts rather than in a straight line. Popular opinion cited above is supportive enough to allow a political party to push a green agenda if it has control of both the White House and Congress. The Biden administration has moderate-to-strong political capital based on our Political Capital Index (Appendix). But this could change with the next election, which would introduce a ruffle in the current narrative in which Biden saves planet earth. One factor that helps Biden is that his presidency is entirely about economic stimulus and recovery, which enables him to minimize the regulatory and punitive side of his party’s energy agenda. While the American Jobs Plan includes corporate tax hikes, his climate policy in itself is all about spending rather than taxation. There is no carbon pricing scheme anywhere to be seen. And Biden’s Transportation Secretary, Pete Buttigieg (“Mayor Pete,” a center-left politician from Indiana), immediately reversed his recent suggestion that the government levy a gasoline tax or vehicle mileage tax. Biden cannot get any revolutionary green measures passed through the Senate, given that moderate Democrats like Senators Joe Manchin of West Virginia and John Tester of Montana hail from coal-heavy states. The Democrats must also pay heed to the swing states for future elections. Biden only narrowly won his home state of Pennsylvania, after pledging to phase out oil and natural gas in the last presidential debate. True, Biden’s American Jobs Plan will remove subsidies for the oil and gas sector – but these subsidies are not very large. Notably, subsidies for renewables already overwhelm those for traditional infrastructure, even under the Trump administration (Chart 10). Chart 10Subsidy Reform Will Promote Renewables Biden's Green Initiatives Biden's Green Initiatives Chart 11Green Policy At Risk In 2022 Midterm Biden's Green Initiatives Biden's Green Initiatives These points underscore the fact that US climate policy is uncertain over the medium term, when the pandemic fades and the Democrats attempt more ambitious climate proposals. The Republican Party supports the traditional energy sector and is skeptical about climate change. The GOP could easily make a net gain of five seats in the 2022 midterm elections and take back control of the House of Representatives. They would not be able to repeal Biden’s laws or regulations, given his veto and likely Democratic majority in the Senate, but they would be able to pare back green funding. Republicans are not uniform on the issue of climate but more than half of Trump supporters in 2020 considered climate change unimportant. Young party members, moderates, and women were more split on the issue, with 60% of moderate Republicans viewing climate change as somewhat or very important (Chart 11). The takeaway is that Republicans would obstruct but not repeal future climate policy. Climate policy would be limited to Biden’s regulations until at least 2024. Hence investors can expect US climate policy to plow forward in the short run but to encounter resistance in the medium run. This is also likely to be the case as various other crises will emerge and soak up government attention and resources (most likely geopolitical conflicts). Chart 12Green Policy More Likely Over Long Term Biden's Green Initiatives Biden's Green Initiatives Over the long run climate policy will have more reliable support. Younger Republicans support federal environmental policy more than their elders, are increasingly favorable toward government regulation to that end, and prefer renewables to fossil fuels (Chart 12). The millennials and younger generations will make up more than half of the electorate by around 2028. Even then the government’s focus on climate will wax and wane given the other pressing matters of the day. Investment Takeaways A tsunami of money has been created, a lot of it is finding its way into the stock market, and a lot of it is finding its way into green and sustainable energy companies – companies that now have a privileged position in terms of both government support and conspicuous consumption. Combine this with a tidal wave of institutional funds pouring into anything and everything labeled ESG (environmental, social, and governance) – and the stigma attached to climate skepticism and denialism – and investors should fully expect irrational exuberance and stock bubbles. Consider the US’s premier EV maker, Tesla. The vertical run-up in Tesla stock has occurred alongside the run-up in US money supply. Tesla’s price trend conforms with the profile of a range of stock market bubbles of the past (Chart 13), as shown by our US Equity Strategy. Chart 13ALow Rates And Vast Money Growth... Low Rates And Vast Money Growth... Low Rates And Vast Money Growth... Chart 13B...Will Fuel Green Bubble ...Will Fuel Green Bubble ...Will Fuel Green Bubble That being said, renewables stocks surged throughout 2020 on the back of stimulus and Biden’s likely election – and have since fallen back. They have underperformed cyclical and defensive sectors alike this year to date (Chart 14). As highlighted above, the Democrats’ climate ambitions could yet be pared back in the Senate. However, given the argument in this report, there is sufficient political capital for the climate provisions of the American Jobs Plan to pass. Renewable plays should recover, at least on a tactical, “buy the rumor, sell the news” basis. To play Biden’s American Jobs Plan, our US Equity Strategist Anastasios Avgeriou constructed a “Biden Fiscal Advantage Basket” comprising eight ETFs and one stock, all equal weighted (Chart 15, top panel). Instead of buying specific stocks, Anastasios opted for ETFs so as to diversify away company-specific risk. Chart 14Renewables Corrected But Will Recover Renewables Corrected But Will Recover Renewables Corrected But Will Recover Chart 15Introducing The Biden Fiscal Advantage Basket Introducing The Biden Fiscal Advantage Basket Introducing The Biden Fiscal Advantage Basket The goal was to filter for ETFs that hold mostly US companies and that offered the highest possible liquidity. From a portfolio construction perspective, he aimed to match the different spending segments of Biden’s White House proposal with an ETF. The ticker symbols included in the basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. Granted there is some replication of stocks included in these ETFs. In certain ETFs there is also a sizable international stock exposure, including EM and Chinese stocks. One final caveat is that these ETFs have a high concentration of technology stocks. Our sense is that this basket should outperform the S&P500 on a cyclical and structural basis albeit not tactically (Chart 15, middle panel). However, given the high-tech exposure, our preferred way to express this trade is via a long/short pair trade versus the QQQ high-tech ETF, which tracks the largest 100 companies on the Nasdaq stock exchange (Chart 15, bottom panel). Table 1 shows a number of related ETFs that did not make the cut but that readers may find intriguing and that deserve further research. Later this month we will publish a joint special report with our US Equity Strategy service, updating our views on Biden’s proposals and elaborating on this equity basket. Table 1Infrastructure and Renewables Related ETFs Biden's Green Initiatives Biden's Green Initiatives More broadly, US equities are still enjoying a positive cyclical backdrop, whereas the passage of the American Jobs Plan later this year has a 50% chance of marking peak stimulus (the American Families Plan may not pass). Tactically, however, we are more cautious. There are also several pronounced foreign policy stress tests facing the Biden administration imminently, including serious Russia/Ukraine, Israel/Iran, and China/Taiwan saber-rattling that we fully expect to engender volatility and safe-haven flows. At least one FOMC member, Saint Louis Fed President Jim Bullard, is now openly thinking about thinking about the Fed’s tapering asset purchases – that is, once the US vaccination rate reaches 75%. Our US Investment Strategy recently showed that this rate of vaccination could be reached as early as September.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1Political Risk Matrix Biden's Green Initiatives Biden's Green Initiatives Table A2Political Capital Index Biden's Green Initiatives Biden's Green Initiatives Table A3APolitical Capital: White House And Congress Biden's Green Initiatives Biden's Green Initiatives Table A3BPolitical Capital: Household And Business Sentiment Biden's Green Initiatives Biden's Green Initiatives Table A3CPolitical Capital: The Economy And Markets Biden's Green Initiatives Biden's Green Initiatives Table A4Biden’s Cabinet Position Appointments Biden's Green Initiatives Biden's Green Initiatives